Difficulty: Introductory | Prerequisites: None, though a basic understanding of scarcity and opportunity cost (Chapter 1–3) will help.
This chapter introduces the two foundational models of microeconomics: demand and supply. Every market analysis you encounter in this course builds on the relationships covered here, so treat this as load-bearing material. If you missed the first few weeks, that is fine: this chapter is largely self-contained. You should come away knowing what demand and supply curves represent, why they slope the way they do, and what causes them to shift.
Demand is the quantity of a good consumers are willing and able to buy at each price; supply is the quantity producers are willing and able to sell. Demand slopes downward (higher price, less bought) and supply slopes upward (higher price, more sold). Both curves can shift when outside factors change: income, prices of related goods, expectations, population, tastes, or production conditions.
Demand
The quantity of a good that consumers are willing and able to buy at a given price during a certain period, other things constant.
In simple terms, this means: how much of something people would purchase at each possible price.
Law of demand
The quantity of a good that consumers are willing and able to buy per period varies inversely with the price, other things constant. Higher price, less bought; lower price, more bought.
Think of it as: the basic rule that price and quantity demanded move in opposite directions.
Substitution effect of a price change
When the price of a good falls, it becomes cheaper relative to other goods, making consumers more willing to substitute towards it.
Think of it as: a price drop makes a good look like a better deal compared to its alternatives.
Income effect of a price change
A fall in the price of a good increases consumers' real income, making them more able to purchase goods. For a normal good, the quantity demanded increases.
Think of it as: when something gets cheaper, your money goes further, so you can buy more overall.
Money income
The number of dollars a person receives per period (e.g. £400 per week). This is the raw number on your payslip.
Real income
Income measured by the goods and services it can buy. Real income changes when prices change, even if money income stays the same.
Think of it as: what your money can actually get you, not just the number on the cheque.
Demand curve
A curve showing the relation between the price of a good and the quantity consumers are willing and able to buy per period, other things constant. Slopes downward from left to right.
Demand schedule
A table of price-quantity pairs that make up the demand curve. Each row is one coordinate on the curve.
Quantity demanded
The amount of a good consumers are willing and able to buy per period at a particular price, reflected by a single point on a demand curve.
In simple terms, this means: one specific number at one specific price, not the whole curve.
Normal good
A good for which demand increases (shifts rightward) as consumer income rises. Most goods are normal goods.
Think of it as: the stuff you buy more of when you get a pay rise, like new clothes or restaurant meals.
Inferior good
A good for which demand decreases (shifts leftward) as consumer income rises.
Think of it as: the stuff you stop buying when you can afford better, like instant noodles or second-hand clothes.
Substitutes
Goods that relate in such a way that an increase in the price of one shifts the demand for the other rightward.
Think of it as: alternatives you switch between. Tacos and pizza are substitutes: if tacos get expensive, you eat more pizza.
Complements
Goods that relate in such a way that an increase in the price of one shifts the demand for the other leftward.
Think of it as: things you use together. If the price of pizza rises, you buy less Pepsi to go with it.
Tastes
Consumer preferences: likes and dislikes in consumption. Assumed to remain constant along a given demand curve.
Supply
The relation between the price of a good and the quantity that producers are willing and able to sell per period, other things constant.
Law of supply
The quantity of a good that producers are willing and able to sell per period is usually directly related to its price, other things constant. Higher price, more supplied; lower price, less supplied.
Think of it as: the mirror image of the law of demand. Producers are keener to sell when they can charge more.
The concept of demand
Demand is about willingness and ability to buy. Wanting something is not enough; you must also be able to pay for it at the going price.
Wants are unlimited (you might want a sports car), but demand is constrained by price and income.
A "need" is different from demand. You might need a new muffler, but if the price is more than you can pay, there is no effective demand.
The law of demand
Price and quantity demanded move in opposite directions, other things held constant.
Two mechanisms explain why:
Substitution effect: when a good's price falls, it becomes cheaper relative to alternatives, so consumers switch towards it.
Income effect: when a good's price falls, consumers' real income rises (their money stretches further), so they can buy more of the good.
Scarcity is the background condition. The degree of scarcity of one good relative to another helps determine each good's relative price.
Money income vs real income
Money income is the raw dollar figure you receive per period (e.g. $400 per week).
Real income is what that money can actually purchase. If prices fall, your real income rises even though your money income has not changed.
The income effect works through real income, not money income.
A demand schedule is a table listing price-quantity pairs. Each row is a coordinate you could plot.
A demand curve is the graphical version of that schedule: price on the vertical axis, quantity on the horizontal axis. It slopes downward because of the law of demand.
Quantity demanded refers to a single point on the curve (one price, one quantity). Do not confuse it with "demand," which refers to the entire curve.
In most contexts, "demand" means market demand: the horizontal sum of every individual consumer's demand at each price.
Key distinction: movement along vs shift of the curve
A change in the good's own price causes a movement along the demand curve (a change in quantity demanded).
A change in any other factor (income, prices of related goods, expectations, population, tastes) causes the entire curve to shift (a change in demand).
Five factors shift the demand curve. A useful mnemonic: I-P-E-N-T (Income, Prices of other goods, Expectations, Number of consumers, Tastes).
1. Consumer income
For a normal good, higher income shifts demand rightward. Pizza, new clothes, dining out: you buy more when you earn more.
For an inferior good, higher income shifts demand leftward. Used clothing, instant noodles: you buy less when you can afford something better.
Most goods are normal goods.
2. Prices of other goods
Substitutes (tacos and pizza): if the price of tacos rises, the demand for pizza shifts rightward. Consumers switch to the relatively cheaper alternative.
Complements (Pepsi and pizza): if the price of pizza rises, the demand for Pepsi shifts leftward. You buy less of the thing that goes with the now-expensive good.
3. Consumer expectations
Expectations about future income or future prices can shift current demand. A worker who learns about an upcoming pay rise may start spending more now, shifting demand rightward before the rise takes effect.
4. Number or composition of consumers
More consumers in the market shifts demand rightward. Population growth, immigration, or a new demographic entering the market (e.g. a university opening nearby) all increase market demand.
5. Consumer tastes
Changes in preferences, fashion, or culture shift demand. A viral food trend shifts demand for that food rightward.
Tastes are assumed constant along a given demand curve. When tastes change, the curve shifts.
The concept of supply
Supply is the relation between the price of a good and the quantity producers are willing and able to sell per period, other things constant.
Like demand, supply requires both willingness and ability.
The law of supply
The quantity supplied is usually directly (positively) related to the price, other things constant.
Higher price, more supplied. Lower price, less supplied.
The supply curve slopes upward from left to right.
The logic: higher prices make production more profitable, attracting more output from existing firms and potentially drawing new firms into the market.
Real-world application
Farmers illustrate the law of supply neatly. When wheat prices rise, farmers plant more wheat (and perhaps convert land from other crops). When prices fall, they scale back. The same logic applies to any producer deciding how much to bring to market.
Students often confuse a change in quantity demanded (movement along the curve, caused by a price change) with a change in demand (shift of the entire curve, caused by an outside factor). This is the single most common error on exams for this chapter.
Students sometimes think "demand" means the amount people buy. Demand is the entire relationship between price and quantity, not a single number.
"Inferior good" does not mean the good is low quality. It means demand for it falls when income rises. A perfectly decent good can be inferior if people replace it with something they prefer once they can afford to.
Students often assume that if two goods are related, they must be substitutes. Complements are equally common. The test is what happens to the demand for Good B when the price of Good A rises: rightward shift means substitutes, leftward shift means complements.
⚠️ "Change in quantity demanded" vs "change in demand" is tested relentlessly. Know the difference cold.
⚠️ Be able to identify which demand shifter is at work in a scenario question (income change, substitute price change, etc.) and state the direction of the shift.
⚠️ Normal goods vs inferior goods: expect a question asking you to classify a good based on how demand responds to an income change.
⚠️ The substitution effect and the income effect both explain why the demand curve slopes downward. You may be asked to explain the downward slope using both.
⚠️ The law of supply (positive relationship between price and quantity supplied) is often tested alongside the law of demand. Be ready to compare and contrast their slopes.
True or false: a rise in the price of a good causes the demand curve to shift leftward.
False. A rise in the good's own price causes a movement along the demand curve, not a shift.
Fill in the blank: a good for which demand decreases as income rises is called a(n) ________ good.
Inferior good.
True or false: the substitution effect says that when a good's price falls, consumers' real income rises.
False. That is the income effect. The substitution effect says the good becomes cheaper relative to alternatives.
Fill in the blank: if the price of tacos rises and the demand for pizza increases, tacos and pizza are ________.
Substitutes.
True or false: the law of supply states that price and quantity supplied move in opposite directions.
False. The law of supply states they move in the same direction (positively related).
Q: Explain why the demand curve slopes downward, using both the substitution effect and the income effect.
A: When the price of a good falls, it becomes cheaper relative to other goods, so consumers substitute towards it (substitution effect). At the same time, the price drop increases consumers' real income, allowing them to buy more goods overall, including more of the cheaper good if it is a normal good (income effect). Both effects cause quantity demanded to rise when price falls, producing the downward slope.
Q: A report shows that as average household income in a city rose by 10%, purchases of public bus passes fell by 5%. Is a public bus pass a normal good or an inferior good? Explain.
A: It is an inferior good. Demand for bus passes fell as income rose, which is the defining characteristic of an inferior good. Consumers likely switched to driving or ride-sharing as they could afford to.
Q: The price of cinema tickets rises sharply. What is the likely effect on demand for streaming subscriptions, and why?
A: Demand for streaming subscriptions shifts rightward. Cinema and streaming are substitutes: both provide filmed entertainment. When cinema becomes more expensive, consumers switch to the relatively cheaper alternative.
Q: Petrol prices rise. What happens to the demand for large SUVs, and what type of related goods are petrol and SUVs?
A: Demand for large SUVs shifts leftward. Petrol and SUVs are complements (SUVs consume large quantities of petrol). A rise in the price of petrol makes running an SUV more expensive, reducing demand for them.
Q: Name the five factors that can shift a demand curve.
A: Consumer income, prices of other goods (substitutes and complements), consumer expectations, the number or composition of consumers in the market, and consumer tastes.
This chapter connects directly to market equilibrium (Chapter 5 in most textbooks), where demand and supply curves intersect to determine the market price and quantity. Understanding shifts here is essential for predicting how equilibrium changes.
The income and substitution effects reappear in consumer theory and the derivation of individual demand curves. Elasticity (typically Chapter 6) builds on the demand and supply curves introduced here by measuring how responsive quantity is to changes in price, income, or the price of related goods.
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