Demand, Supply and Market Equilibrium
What the exam tests
Demand, supply and equilibrium is the foundation for price formation. CB2 questions ask you to identify non-price determinants, shift curves correctly and compute equilibrium with and without government intervention.
Core rules
- The law of demand says quantity demanded falls as own price rises, ceteris paribus; supply rises with price.
- Own-price changes cause movements along a curve. Income, tastes, related-good prices, expectations and buyer numbers shift demand. Input costs, technology, taxes, subsidies and seller numbers shift supply.
- Substitutes have positive cross-price effects; complements have negative effects. Normal goods have positive income effects; inferior goods negative.
- Equilibrium is where quantity demanded equals quantity supplied. Excess demand bids price up; excess supply bids it down.
Worked example
Let Qd = 100 - 2P and Qs = 20 + 3P. Set 100 - 2P = 20 + 3P, so 80 = 5P and P = 16. Then Q = 100 - 32 = 68. A price ceiling of 12 gives Qd = 76 and Qs = 56, a shortage of 20. A price floor of 20 gives Qd = 60 and Qs = 80, a surplus of 20. The ceiling prevents price rising to clear the shortage; the floor prevents price falling to clear the surplus.
Traps
- Calling a price change a shift in demand rather than a movement along it.
- Forgetting that a demand shift changes both equilibrium price and quantity; the direction depends on which curve moves.
- Assuming a price ceiling helps suppliers or that a floor helps buyers; the short side of the market determines actual quantity traded.
- Mixing up inferior goods with Giffen goods, which are a special case where the income effect dominates.