Demand, Supply, and Market Equilibrium
O
Oiyo Contributor
Chapter 2: Demand, Supply, and Market Equilibrium
In a market economy, price acts as the ‘invisible hand’. Understanding how price and quantity are determined where demand and supply meet is the core of economics.
1. Basics of Demand and Supply
(1) Demand
- Law of Demand: As the price of a good increases, the quantity demanded decreases, and as the price decreases, the quantity demanded increases (inverse relationship).
- Change in Quantity Demanded vs. Change in Demand:
- Change in Quantity Demanded: A movement along the curve caused by a change in the price of the good itself.
- Change in Demand: A shift of the entire curve caused by factors other than price (income, tastes, prices of related goods, etc.).
(2) Supply
- Law of Supply: As the price of a good increases, the quantity supplied increases, and as the price decreases, the quantity supplied decreases (direct relationship).
2. Market Equilibrium
The point where the quantity demanded equals the quantity supplied determines the Equilibrium Price and Equilibrium Quantity.
| State | Description | Change in Price |
|---|---|---|
| Shortage (Excess Demand) | Quantity Demanded > Quantity Supplied | Price Increases |
| Surplus (Excess Supply) | Quantity Supplied > Quantity Demanded | Price Decreases |
3. Elasticity
A measure of how sensitive demand or supply is to changes in price or income.
(1) Price Elasticity of Demand ()
- (Elastic): The percent change in quantity is larger than the percent change in price. (Common when there are many substitutes)
- (Inelastic): The percent change in quantity is smaller than the percent change in price. (Common for necessities)
(2) Income and Cross-Price Elasticity
- Income Elasticity > 0: Normal Good / Income Elasticity < 0: Inferior Good
- Cross-Price Elasticity > 0: Substitutes / Cross-Price Elasticity < 0: Complements
4. Consumer and Producer Surplus
- Consumer Surplus: The difference between the maximum amount a consumer is willing to pay and the actual price paid.
- Producer Surplus: The difference between the actual price received and the minimum amount a producer is willing to accept.
- Total Welfare (Social Surplus) = Consumer Surplus + Producer Surplus
Social welfare is maximized when the market is allowed to reach equilibrium freely. Government intervention like taxes or price controls can lead to Deadweight Loss.
Key Checklist
- If the price of Cola rises, how does the demand for Cider change? (Cross-price elasticity perspective)
- If technological innovation reduces production costs, which way does the supply curve shift?
- What do we call the case where the price elasticity of demand is 0? (Answer: Perfectly Inelastic)
- What phenomenon occurs when the market price is higher than the equilibrium price? (Answer: Surplus)
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