Demand and supply
Demand and supply is the most widely used model in economics. It explains how prices are set and why they change.
The law of demand
The law of demand says that, other things equal, as the price of a good rises, the quantity demanded falls. This happens because of the substitution effect (people switch to cheaper alternatives) and the income effect (a higher price makes buyers effectively poorer). A demand curve slopes downward.
Shifts in demand
A change in the good's own price moves along the demand curve (a change in quantity demanded). Other factors shift the whole curve (a change in demand): income, prices of related goods, tastes, expectations, and the number of buyers. For a normal good, higher income raises demand; for an inferior good, such as instant noodles, it lowers demand.
Substitutes and complements
Substitutes are used in place of each other, like tea and coffee: a rise in coffee's price raises demand for tea. Complements are used together, like printers and ink: a rise in printer prices lowers demand for ink. Recognising these links lets firms anticipate the effects of competitors' pricing.
The law of supply
The law of supply says that, other things equal, as price rises, the quantity supplied rises, because higher prices make production more profitable and cover rising marginal costs. A supply curve slopes upward.
Shifts in supply
Supply shifts with input costs, technology, the number of sellers, expectations, taxes and subsidies, and prices of other goods the producer could make. Cheaper inputs or better technology shift supply to the right; a new tax on producers or a bad harvest shifts it left.
Equilibrium
Equilibrium is where the demand and supply curves cross: the quantity buyers want equals the quantity sellers offer. Above the equilibrium price there is a surplus, pushing prices down; below it there is a shortage, pushing prices up. Markets tend toward equilibrium as buyers and sellers respond.
Finding equilibrium algebraically
Suppose demand is \(Q_d = 100 - 2P\) and supply is \(Q_s = 20 + 2P\). Setting them equal: \(100 - 2P = 20 + 2P\), so \(4P = 80\) and \(P = 20\). Then \(Q = 100 - 40 = 60\). At a price of 20, buyers want 60 units and sellers offer 60.
Common mistakes
Confusing a change in quantity demanded (movement along the curve due to price) with a change in demand (a shift due to other factors). Saying 'price rises, so demand falls, so price falls': a price change does not shift its own demand curve. Forgetting that both curves can shift at once.
Key takeaways
Demand slopes down because of substitution and income effects; supply slopes up because higher prices cover rising costs. Own-price changes move along curves; other factors shift them. Substitutes and complements link markets. Equilibrium is where the curves cross; surpluses push prices down and shortages push them up.
Flashcard
Higher price, lower quantity demanded
Check your understanding
The price of coffee rises sharply. What happens to the demand for tea?