Demand, Supply & Equilibrium
Law of demand, law of supply, determinants, equilibrium price and quantity, and surplus/shortage
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Demand, Supply, and Market Equilibrium
The interaction of demand and supply is the central model in microeconomics. It explains how prices are set in competitive markets and why those prices change over time.
Demand
The law of demand states that, all else equal, when the price of a good rises, quantity demanded falls (and vice versa). The demand curve slopes downward for two reasons: the substitution effect (consumers switch to relatively cheaper alternatives as price rises) and the income effect (a higher price reduces real purchasing power, lowering quantity bought).
A change in quantity demanded is a movement ALONG the demand curve caused only by a change in the good's own price. A change in demand is a SHIFT of the entire curve, caused by:
- Changes in income (normal goods shift right as income rises; inferior goods shift left).
- Changes in the price of related goods (substitutes and complements).
- Changes in tastes/preferences.
- Changes in the number of buyers.
- Changes in expectations of future prices.
Supply
The law of supply states that, all else equal, higher prices induce producers to supply more — the supply curve is upward-sloping because higher prices cover rising marginal costs and make production more profitable. Supply shifts in response to changes in input prices, technology, the number of sellers, government taxes/subsidies, and producer expectations.
Equilibrium
Equilibrium is the price–quantity combination at which — the demand and supply curves cross. At any price above equilibrium there is a surplus () and downward pressure on price; below equilibrium there is a shortage and upward pressure on price. Markets self-correct toward equilibrium through these price signals.
Predicting Equilibrium Changes
When only one curve shifts, both equilibrium price and quantity move predictably. When both curves shift simultaneously, one of the two outcomes (price or quantity) is indeterminate without knowing the relative size of the shifts — a frequent FRQ trap.
| Shift | ||
|---|---|---|
| Demand right (↑D) | ↑ | ↑ |
| Demand left (↓D) | ↓ | ↓ |
| Supply right (↑S) | ↓ | ↑ |
| Supply left (↓S) | ↑ | ↓ |
| ↑D and ↑S | ? | ↑ |
| ↑D and ↓S | ↑ | ? |
Consumer and Producer Surplus
Consumer surplus = area BELOW the demand curve and ABOVE the price (what buyers were willing to pay minus what they paid). Producer surplus = area ABOVE the supply curve and BELOW the price. Their sum is total surplus, which is maximized at competitive equilibrium.
📚 Practice Problems
1Problem 1easy
❓ Question:
Coffee and tea are substitutes. If a frost destroys much of the world's coffee crop, predict the effect on the equilibrium price and quantity in the tea market. Briefly justify which curve shifts.
💡 Show Solution
The frost reduces coffee supply, raising coffee's equilibrium price. Because tea is a substitute, consumers switch toward tea ⇒ demand for tea shifts right.
Result in the tea market: equilibrium price rises, equilibrium quantity rises.
2Problem 2easy
❓ Question:
In the market for smartphones, the demand schedule and supply schedule are: at $400, and . At $500, and . At $600, and . Identify the equilibrium price and quantity, and identify any shortage or surplus at $400.
💡 Show Solution
Equilibrium occurs where : at P = \500Q^* = 60$500$, 60 phones.**
At P = \400Q_d = 80 > Q_s = 40$ ⇒ shortage of 40 units, putting upward pressure on price.
3Problem 3medium
❓ Question:
In the market for new homes, suppose lumber prices fall AND average household incomes rise. Homes are a normal good. Predict, with reasoning, the directions of the change in equilibrium price and quantity. Identify any indeterminate outcome.
💡 Show Solution
Effect of lower lumber prices: input cost falls ⇒ supply shifts right (, ).
Effect of higher income: homes are a normal good ⇒ demand shifts right (, ).
Combined:
- : both effects increase quantity ⇒ rises.
- : supply pushes price down, demand pushes price up ⇒ is indeterminate without knowing which shift is larger.
4Problem 4medium
❓ Question:
Linear demand is given by and linear supply by . (a) Find the equilibrium price and quantity. (b) Compute consumer surplus at equilibrium.
💡 Show Solution
(a) Set : 120 - 2P = 4P - 60 \Rightarrow 180 = 6P \Rightarrow P^* = \30Q^* = 120 - 2(30) = 60$.
(b) The demand curve hits the price-axis (where ) at . Consumer surplus is the area of the triangle with base and height :
CS = \tfrac{1}{2}(60)(30) = \boxed{\900}.$
5Problem 5hard
❓ Question:
The equilibrium price of gasoline rises sharply after a refinery explosion. A student claims, "This proves the law of demand is wrong, since the higher price didn't reduce gasoline use much." Critique this claim, distinguishing between movement along a curve and a shift of a curve.
💡 Show Solution
The student is conflating two different concepts.
The refinery explosion shifts the supply curve LEFT, not the demand curve. Equilibrium moves along the (unchanged) demand curve to a new point at higher price and lower quantity. The fact that quantity demanded fell somewhat in response to the higher price IS the law of demand at work.
If gasoline use barely fell, that says demand is inelastic (steep), not that the law of demand is violated. The law states only the direction of the response (Q falls when P rises), not its magnitude. So the student's evidence is consistent with — not contradictory to — the law of demand.
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