Source: Intermediate Microeconomics, Florida International University
Difficulty: Intermediate | Prerequisites: Consumer theory (indifference curves, budget constraints, optimal bundles).
Once you understand how an individual consumer chooses, the next step is to build a market. This section covers how individual demand curves aggregate into market demand, how responsive consumers are to price changes (elasticity), and how supply and demand interact to determine equilibrium. These concepts appear in nearly every topic that follows, from welfare analysis to market structure. You should be comfortable with the tangency method for finding optimal bundles before working through this material.
Market demand is the horizontal sum of individual demand curves. Elasticity measures how much quantity demanded responds to a price change. Supply and demand together set the equilibrium price and quantity, and consumer and producer surplus measure the welfare gains from trade.
Price elasticity of demand (E or Ed)
The percentage change in quantity demanded divided by the percentage change in price. In simple terms, it tells you how sensitive buyers are to a price change.
Elastic demand (|E| > 1)
Consumers respond strongly to price changes. A small price increase leads to a proportionally larger drop in quantity demanded.
Inelastic demand (|E| < 1)
Consumers are relatively unresponsive to price changes. Quantity demanded barely moves.
Unitary elastic demand (|E| = 1)
The percentage change in quantity exactly matches the percentage change in price.
Perfectly elastic (|E| = infinity)
Consumers stop buying entirely at even a tiny price increase. Represented by a horizontal demand curve.
Perfectly inelastic (|E| = 0)
Consumers buy the same quantity regardless of price. Represented by a vertical demand curve.
Arc elasticity
Elasticity calculated using the average of two price-quantity points. Used when you have data from a graph or a table but no equation.
Point elasticity
Elasticity calculated at a specific point on a demand curve using the derivative. Used when you have a demand equation.
Market demand
The horizontal summation of all individual demand curves. You add quantities (not prices) at each price level.
Consumer surplus
The area between the demand curve and the market price, above the equilibrium price line. It represents the total amount buyers would have been willing to pay above what they actually paid.
Producer surplus
The area between the supply curve and the market price, below the equilibrium price line. It represents the total amount sellers receive above the minimum they would have accepted.
To find market demand, add individual quantities at each price. You sum Q, not P.
Worked example:
Mario's demand for mushrooms: P = 24 - 2Qm
Luigi's demand for mushrooms: P = 16 - 8Ql
Steps:
Rearrange each in terms of Q: Qm = (24 - P) / 2 and Ql = (16 - P) / 8.
Sum the quantities: Q_market = Qm + Ql.
If needed, rearrange back in terms of P.
Aggregating individual demand to market demand is what allows us to calculate consumer surplus for the entire market.
Elasticity (E) measures the percentage change in quantity demanded for a 1% increase in price. The absolute value tells you how responsive consumers are.
|E| > 1: elastic. Consumers respond strongly. A 1% price rise causes more than a 1% drop in quantity.
|E| = 1: unitary elastic. Proportional response.
|E| < 1: inelastic. Consumers barely respond. A 1% price rise causes less than a 1% drop in quantity.
|E| = infinity: perfectly elastic. A horizontal demand curve. Even a tiny price increase kills all demand.
|E| = 0: perfectly inelastic. A vertical demand curve. Quantity demanded is the same at any price.
Example: if a 1% increase in the Spotify subscription price decreases subscribers by 2%, the elasticity is -2 (elastic).
General formula: E = (% change in Q) / (% change in P) = (ΔQ/Q) / (ΔP/P)
Arc elasticity (midpoint method): use when you have two data points from a graph or table but no equation. Use the average Q and average P as the base.
Point elasticity: use when you have a demand equation.
Take the derivative dQ/dP from the equation.
Multiply by P/Q at the point you are evaluating.
Worked example (point elasticity): Q = 100 - 4P, P = $10.
dQ/dP = -4.
At P = 10: Q = 100 - 4(10) = 60.
E = (-4)(10/60) = -2/3. Since |E| < 1, demand is inelastic at this price.
Four main factors determine how responsive consumers are to price changes:
Availability of substitutes: the closer the substitutes, the more elastic. Uber vs Lyft: very elastic, because switching is easy. A local utility provider: inelastic, because there is no alternative.
Time horizon: demand tends to be more inelastic in the short run (if your phone breaks, you pay whatever it costs now) and more elastic in the long run (you shop around, find alternatives). There can be distinct short-run and long-run elasticities.
Habit and dependency: goods that are part of a daily routine or that create dependency (coffee, tobacco) tend to be inelastic. Consumers stick with them despite price rises.
Proportion of budget: more expensive items take up a larger share of income, so their income effects are larger. For normal goods, this reinforces the substitution effect, making demand more elastic.
Consumer surplus is the triangle above the equilibrium price and below the demand curve. Producer surplus is the triangle below the equilibrium price and above the supply curve. Together they represent the total gains from trade in the market.
Surplus vs shortage:
Excess supply (surplus) occurs when price is above equilibrium. Sellers have unsold stock.
Excess demand (shortage) occurs when price is below equilibrium. Buyers cannot find enough.
Movement along vs shifting the curve:
A change in the good's own price causes movement along the existing curve. A shift of the entire curve is caused by something other than the good's own price.
Factors that shift the supply curve:
Technology improvements (e.g. better battery technology makes smartwatches cheaper to produce)
Factor prices (wages, raw materials, interest rates)
Weather
Number of firms in the market
Factors that shift the demand curve:
Income
Tastes and preferences
Prices of other goods (substitutes and complements)
Population
Tax incidence: when a $100 tax is levied on producers (or on consumers), the price paid by consumers rises by less than $100. The burden is shared between buyers and sellers, and the split depends on the relative elasticities of supply and demand.
Students often confuse a shift of the demand curve with a movement along it. A change in the good's own price moves you along the curve. A change in income, tastes, or other prices shifts the whole curve.
Students sometimes think elasticity and slope are the same thing. They are related but distinct. Elasticity uses percentage changes, so the same slope can produce different elasticities at different points on the curve.
A common mistake is adding prices (P) rather than quantities (Q) when aggregating individual demand curves. Always sum Q horizontally at each price level.
Students sometimes assume that a tax levied on producers is paid entirely by producers. In practice, the burden is shared with consumers depending on relative elasticities.
⚠️ Know both the arc and point methods for calculating elasticity and when to use each.
⚠️ Be able to aggregate two individual demand curves into a market demand curve step by step.
⚠️ Identify which factors shift supply vs demand, and in which direction.
⚠️ Be prepared to find consumer and producer surplus graphically (the triangles above and below equilibrium price).
⚠️ Understand that the same tax has the same effect on equilibrium regardless of whether it is levied on buyers or sellers.
True or False: To find market demand, you add individual prices at each quantity. (False, you add quantities at each price)
Fill in the blank: If |E| > 1, demand is ______ . (elastic)
True or False: A change in income shifts the supply curve. (False, it shifts the demand curve)
Fill in the blank: Consumer surplus is the area between the ______ curve and the ______ price. (demand, equilibrium)
True or False: Point elasticity requires a demand equation. (True)
Q: If Q = 100 - 4P and P = $10, what is the point elasticity of demand? Is demand elastic or inelastic at this price?
A: dQ/dP = -4. At P = 10, Q = 60. E = (-4)(10/60) = -2/3. Since |E| < 1, demand is inelastic.
Q: Mario's demand is P = 24 - 2Qm and Luigi's is P = 16 - 8Ql. What is the first step to find market demand?
A: Rearrange each equation in terms of Q: Qm = (24 - P)/2 and Ql = (16 - P)/8. Then sum the quantities at each price.
Q: Name two factors that shift the supply curve and two that shift the demand curve.
A: Supply shifters include technology and factor prices (e.g. wages, raw materials). Demand shifters include income and tastes/preferences.
Q: A $100 tax is levied on producers. Does the consumer price rise by $100?
A: No. The price rises by less than $100. The tax burden is shared between buyers and sellers based on their relative elasticities.
Elasticity feeds directly into producer theory: a firm's pricing power depends on how elastic its customers are, which connects to monopoly and price discrimination. Consumer and producer surplus reappear in welfare analysis, deadweight loss from taxes, and evaluating policy interventions. The supply shifters here (technology, factor prices) link to production theory and cost analysis.
Tags: price elasticity of demand, arc elasticity, point elasticity, midpoint method, elastic, inelastic, unitary elastic, perfectly elastic, perfectly inelastic, market demand, horizontal summation, consumer surplus, producer surplus, supply and demand, equilibrium, surplus, shortage, excess supply, excess demand, supply shifters, demand shifters, tax incidence, substitutes, complements, normal good, inferior good, intermediate microeconomics