Supply Demand Curves

Why This Matters

Supply and demand curves aren't just abstract graphs—they're the fundamental language economists use to explain how markets work. You're being tested on your ability to analyze why prices change, how markets reach balance, and what happens when external forces disrupt that balance. Every question about pricing strategy, market intervention, or consumer behavior traces back to these core concepts.

Here's the key insight: the exam doesn't just want you to draw curves. It wants you to predict outcomes. When you understand the mechanisms behind shifts, elasticity, and surplus, you can tackle any scenario—whether it's a government imposing a price ceiling or a new technology disrupting an industry. Don't just memorize the shapes of curves; know what forces move them and what happens when they do.

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The Core Laws: How Price and Quantity Relate

The foundation of market analysis rests on two inverse relationships—demand slopes down because consumers buy more when prices fall, while supply slopes up because producers offer more when prices rise.

Law of Demand

• Inverse price-quantity relationship—as price decreases, quantity demanded increases, creating the characteristic downward-sloping curve
• Consumer decision-making drives this behavior; lower prices mean greater purchasing power and more utility per dollar spent
• Determinants beyond price include income, preferences, expectations, and prices of related goods—these shift the entire curve

Law of Supply

• Direct price-quantity relationship—as price increases, quantity supplied increases, creating the upward-sloping curve
• Profit incentive explains the mechanism; higher prices make production more attractive and cover marginal costs for additional units
• Non-price determinants include input costs, technology, number of sellers, and expectations—these shift the entire curve

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Market Equilibrium: Where Forces Balance

Equilibrium represents the market's natural resting point—the price at which buyers' and sellers' plans align perfectly, eliminating pressure for change.

Equilibrium Price and Quantity

• Market-clearing price occurs where quantity demanded equals quantity supplied, written as $Q_d = Q_s$
• No surplus or shortage exists at equilibrium; every unit produced finds a willing buyer at the prevailing price
• Self-correcting mechanism—prices above equilibrium create surpluses that push prices down; prices below create shortages that push prices up

Shortage and Surplus

• Shortage (excess demand) occurs when $Q_d > Q_s$, typically because price is below equilibrium, creating upward pressure on prices
• Surplus (excess supply) occurs when $Q_s > Q_d$, typically because price is above equilibrium, creating downward pressure on prices
• Disequilibrium signals—both conditions indicate markets haven't cleared and prices will adjust toward equilibrium

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Curve Shifters: What Moves Entire Curves

Understanding shifts is critical—a change in price causes movement along a curve, but a change in any other factor shifts the entire curve to a new position.

Shifts in Demand Curve

• Rightward shift indicates increased demand at every price level; leftward shift indicates decreased demand
• TIPE factors cause shifts: Tastes, Income, Prices of related goods, Expectations, and number of buyers
• New equilibrium results from demand shifts—rightward shifts raise both price and quantity; leftward shifts lower both

Shifts in Supply Curve

• Rightward shift indicates increased supply at every price level; leftward shift indicates decreased supply
• ROTTEN factors cause shifts: Resource costs, Other goods' prices, Technology, Taxes/subsidies, Expectations, and Number of sellers
• New equilibrium results from supply shifts—rightward shifts lower price but raise quantity; leftward shifts raise price but lower quantity

Complementary and Substitute Goods

• Complements are consumed together (printers and ink)—a price increase in one decreases demand for the other
• Substitutes can replace each other (Coke and Pepsi)—a price increase in one increases demand for the other
• Cross-price elasticity distinguishes them: negative for complements, positive for substitutes

Normal and Inferior Goods

• Normal goods see demand increase when income rises (restaurant meals, vacations)—positive income elasticity
• Inferior goods see demand increase when income falls (instant noodles, public transit)—negative income elasticity
• Income effect explains consumer behavior; as purchasing power changes, consumption patterns shift predictably

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Elasticity: Measuring Responsiveness

Elasticity quantifies how sensitive one variable is to changes in another—the percentage change in quantity divided by the percentage change in price.

Price Elasticity of Demand

• Formula: $E_d = \frac{\%\Delta Q_d}{\%\Delta P}$—elastic when $|E_d| > 1$, inelastic when $|E_d| < 1$, unit elastic when $|E_d| = 1$
• Revenue implications—elastic demand means price cuts increase total revenue; inelastic demand means price increases raise total revenue
• Determinants include availability of substitutes, necessity vs. luxury, proportion of income spent, and time horizon

Price Elasticity of Supply

• Formula: $E_s = \frac{\%\Delta Q_s}{\%\Delta P}$—elastic when $E_s > 1$, inelastic when $E_s < 1$
• Production flexibility drives elasticity—firms with spare capacity or easily adjusted inputs have more elastic supply
• Time horizon matters—supply becomes more elastic over longer periods as producers can adjust production capacity

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Surplus and Welfare: Measuring Market Benefits

Economic surplus measures the gains from trade—the difference between what participants are willing to accept and what they actually pay or receive.

Consumer Surplus

• Willingness to pay minus actual price—represents the "deal" consumers get when market price is below their maximum
• Graphically shown as the triangular area above the price line and below the demand curve
• Maximized at equilibrium—any price above equilibrium reduces consumer surplus by pricing out willing buyers

Producer Surplus

• Actual price minus willingness to accept—represents the profit producers earn above their minimum acceptable price
• Graphically shown as the triangular area below the price line and above the supply curve
• Maximized at equilibrium—any price below equilibrium reduces producer surplus by lowering returns

Market Surplus (Total Economic Surplus)

• Sum of consumer and producer surplus—represents total welfare gains from voluntary market exchange
• Allocative efficiency achieved at equilibrium where $\text{Total Surplus} = \text{Consumer Surplus} + \text{Producer Surplus}$ is maximized
• Deadweight loss occurs when markets move away from equilibrium, destroying surplus that neither party captures

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Market Interventions: When Government Steps In

Government policies alter market outcomes—price controls prevent equilibrium from occurring, while taxes and subsidies shift curves and redistribute surplus.

Price Ceilings and Floors

• Price ceiling (maximum price) set below equilibrium creates shortages—quantity demanded exceeds quantity supplied (think rent control)
• Price floor (minimum price) set above equilibrium creates surpluses—quantity supplied exceeds quantity demanded (think minimum wage)
• Deadweight loss results from both interventions as mutually beneficial trades are prevented

Taxes and Subsidies

• Taxes increase costs, shifting supply leftward—equilibrium price rises, quantity falls, and deadweight loss is created
• Subsidies decrease costs, shifting supply rightward—equilibrium price falls, quantity rises, and government bears the cost
• Tax incidence depends on relative elasticities—the more inelastic side (less responsive) bears more of the tax burden

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Quick Reference Table

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Self-Check Questions

1. If a technological breakthrough reduces production costs, which curve shifts and in which direction? What happens to equilibrium price and quantity?

2. Compare and contrast the effects of a price ceiling set below equilibrium versus a price floor set above equilibrium. What type of disequilibrium does each create?

3. A good has highly elastic demand. If a firm raises prices by 10%, what happens to total revenue? What if demand were highly inelastic?

4. Which two concepts—consumer surplus and producer surplus—combine to measure total welfare? Under what market condition is their sum maximized?

5. Coffee and tea are substitutes; coffee and cream are complements. If the price of coffee increases, what happens to the demand curves for tea and cream? Explain the mechanism behind each shift.