Demand, Supply and Market Price Determination
This section covers demand, supply and equilibrium price, which the exam tests with schedules, curves, shifts and price controls. You need to distinguish movements along a curve from shifts and calculate equilibrium from linear equations.
Core rules
- Law of demand: other things equal, quantity demanded falls as price rises. The demand curve slopes downward.
- Law of supply: other things equal, quantity supplied rises as price rises. The supply curve slopes upward.
- A change in price causes movement along the curve. A change in a non-price determinant shifts the curve.
- Demand shifters include income, tastes, prices of related goods, expectations and number of buyers. Supply shifters include input costs, technology, taxes, subsidies, expectations and number of sellers.
- Equilibrium occurs where quantity demanded equals quantity supplied. Above equilibrium there is a surplus; below equilibrium there is a shortage.
- A price ceiling below equilibrium causes shortage; a price floor above equilibrium causes surplus.
Worked example
Demand: Qd = 100 - 2P. Supply: Qs = 20 + 2P. Set Qd = Qs: 100 - 2P = 20 + 2P, so 80 = 4P and P = 20. Then Q = 100 - 40 = 60. At P = 30, Qd = 40 and Qs = 80, so there is a surplus of 40 units. The price will fall toward 20 unless a price floor prevents it.
Traps
Do not shift demand when only price changes; do not confuse a supply shift with quantity supplied; remember that an inferior good’s demand falls when income rises; do not reverse surplus and shortage.