Source: Comprehensive Overview of Microeconomic Theory Concepts (Texas A&M University)
Tags: law of demand, demand curve, supply curve, market equilibrium, perfectly inelastic supply, substitutes in production, price elasticity of demand, price elasticity of supply, elastic, inelastic, unit elastic, total revenue, downward-sloping demand
The law of demand establishes the inverse relationship between price and quantity demanded, while the supply curve slopes upward. Where the two curves cross is market equilibrium. Elasticity measures how sensitive quantity is to price changes, and the elasticity of demand directly determines whether a price increase raises or lowers a firm's total revenue.
Law of demand
The principle that, all else equal, an increase in a good's price leads to a decrease in the quantity demanded, and vice versa. Produces a downward-sloping demand curve.
Demand curve
A graph showing the relationship between a good's price and the quantity consumers wish to buy. Slopes downward (left to right) under the law of demand.
Supply curve
A graph showing the relationship between a good's price and the quantity producers are willing to supply. Typically slopes upward, reflecting that higher prices incentivise greater output.
Market equilibrium
The price and quantity at which the demand curve and supply curve intersect. At equilibrium, quantity demanded equals quantity supplied.
Perfectly inelastic supply
A supply curve that is vertical: quantity supplied does not change regardless of price. Common in markets for land or goods subject to fixed quotas.
Substitutes in production
Inputs that a firm can use interchangeably. When the price of one input rises, demand for its substitute increases (the substitute's demand curve shifts right).
Price elasticity of demand
A measure of how responsive quantity demanded is to a change in price. Calculated as the percentage change in quantity demanded divided by the percentage change in price.
Price elasticity of supply
A measure of how responsive quantity supplied is to a change in price. Same formula structure as demand elasticity, applied to the supply side.
Elastic demand (or supply)
Elasticity greater than 1 in absolute value. A small price change causes a proportionally larger change in quantity.
Inelastic demand (or supply)
Elasticity less than 1 in absolute value. Quantity responds relatively little to price changes.
Unit elastic demand
Elasticity exactly equal to 1. The percentage change in quantity equals the percentage change in price, so total revenue is unaffected by a price change.
Total revenue
Price multiplied by quantity sold. The direction of its change when price moves depends on the elasticity of demand.
When price falls, quantity demanded rises; when price rises, quantity demanded falls.
This holds ceteris paribus (all else equal).
The intuition is straightforward: goods become more attractive to buyers as they get cheaper.
Graphically, the demand curve slopes downward from left to right.
The demand curve plots price on the vertical axis against quantity demanded on the horizontal axis. Downward slope.
The supply curve plots price against quantity supplied. Upward slope, because higher prices make production more profitable and incentivise firms to supply more.
Market equilibrium sits at the intersection: the unique price-quantity pair where the market clears.
A vertical supply curve means the quantity available does not respond to price at all.
If demand increases in such a market, the entire adjustment happens through price: price rises, but quantity stays the same.
Real-world examples: land (fixed in total supply), certain regulatory quotas, tickets to a sold-out event.
If two inputs can stand in for each other (e.g. plastic and steel for car panels), they are substitutes in production.
A price rise for one input shifts demand for the substitute to the right (firms switch to the cheaper option).
The demand curve for the now-expensive input shifts left.
Elasticity = (% change in quantity) / (% change in price).
Elastic (|E| > 1): quantity is highly responsive to price.
Inelastic (|E| < 1): quantity barely moves when price changes.
Unit elastic (|E| = 1): quantity and price change proportionally.
Inelastic demand (|E| < 1): raising prices increases total revenue, because quantity drops only slightly.
Elastic demand (|E| > 1): raising prices decreases total revenue, because the quantity drop more than offsets the higher price.
Unit elastic demand (|E| = 1): price changes leave total revenue unchanged.
This relationship is central to firms' pricing strategy decisions.
Price elasticity of demand:
E_d = (% change in quantity demanded) / (% change in price)
Example: a 1% price increase causes a 0.5% fall in quantity demanded. E_d = -0.5 (inelastic, since |E_d| < 1).
Total revenue:
TR = P × Q
⚠️ Know the difference between a movement along a demand/supply curve (caused by a price change) and a shift of the curve (caused by a change in some other factor like income, tastes, or input prices).
⚠️ Perfectly inelastic supply is a favourite exam scenario. If supply is vertical, all the action from a demand shift goes into price, not quantity.
⚠️ The elasticity-total revenue relationship is heavily tested. Be able to state what happens to TR when price rises under each elasticity case: inelastic (TR up), elastic (TR down), unit elastic (TR unchanged).
⚠️ Don't confuse substitutes in consumption (goods consumers switch between) with substitutes in production (inputs firms switch between). Both shift demand curves, but for different goods in different markets.
Q: If the supply of beachfront land is perfectly inelastic and demand for it increases, what happens to price and quantity?
A: Price rises. Quantity remains unchanged, because supply cannot respond to the higher demand.
Q: A firm finds that a 10% price increase causes a 15% drop in quantity demanded. Is demand elastic or inelastic, and what happens to total revenue?
A: Elasticity = 15% / 10% = 1.5 (elastic). Total revenue falls, because the quantity loss more than offsets the price gain.
Q: Why does the demand curve slope downward?
A: Because of the law of demand: as price falls, consumers find the good more attractive relative to alternatives and their purchasing power stretches further, so they buy more.
Q: If plastic becomes more expensive, what happens to the demand for steel as a substitute input in production?
A: Demand for steel increases (the steel demand curve shifts to the right) as firms switch away from the now-costlier plastic.
Q: When is raising prices a good strategy for increasing total revenue?
A: When demand is inelastic (|E| < 1), so that the percentage drop in quantity sold is smaller than the percentage increase in price.
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