Source: Lecture Modules 014–038
Tags: market, demand, supply, law of demand, law of supply, demand curve, supply curve, demand shifters, supply shifters, equilibrium, shortage, surplus, quantity demanded, quantity supplied, substitutes, complements, normal good, inferior good, simultaneous shifts
Difficulty: Introductory to Intermediate Prerequisites: Scarcity and opportunity cost (Part 1 of these notes).
Supply and demand is the workhorse model of economics. Nearly every topic later in the course, from GDP fluctuations to government policy, is built on the logic introduced here. This section covers what a market is, how demand and supply are defined and graphed, what shifts each curve, how equilibrium price and quantity are determined, and what happens when both curves move at once. Master this, and you have the toolkit for most of the analysis in the rest of the course.
Demand slopes downward (people buy more at lower prices). Supply slopes upward (sellers offer more at higher prices). Where the two curves cross is equilibrium. Various non-price factors shift each curve, changing the equilibrium price and quantity. When both curves shift at once, one of the two (price or quantity) becomes ambiguous.
Market
A well-defined group of consumers and sellers for a particular product. The demand and supply model assumes a homogeneous product, many buyers and sellers, perfect information, and a single price.
Demand
The relationship between the quantity demanded of a good or service by all potential consumers and the per-unit price of that good or service. Demand refers to the entire curve, not a single point on it.
Quantity demanded
The specific amount consumers are willing and able to buy at one particular price. Think of it as a single point on the demand curve rather than the whole curve.
For something to count as "quantity demanded," three conditions must hold: the consumer wants it, can afford it, and would buy it at the given price.
Law of demand
As price decreases, quantity demanded increases (and vice versa). This is why the demand curve slopes downward.
Substitution effect
When the price of a good falls, that good becomes cheaper relative to alternatives, so consumers switch toward it.
Income effect (wealth effect)
When the price of a good falls, consumers' purchasing power effectively rises, so they can afford more units.
Demand shifters
Non-price factors that move the entire demand curve to the left or right. The main ones: number of consumers, income, prices of related goods (substitutes and complements), expected future prices, and preferences.
Normal good
A good for which demand increases when income rises (positive relationship with income).
Inferior good
A good for which demand decreases when income rises (negative relationship with income). Think of it as the budget option you buy less of once you earn more.
Substitutes
Goods that serve a similar purpose. When the price of one rises, demand for the other increases (positive relationship between the price of one and the demand for the other).
Complements
Goods that are consumed together (e.g. hot dogs and buns). When the price of one rises, demand for the other decreases (negative relationship).
Supply
The relationship between the quantity supplied of a good or service by all potential sellers and the per-unit price. Supply refers to the entire curve.
Quantity supplied
The specific amount sellers are willing and able to sell at one particular price. A single point on the supply curve.
Law of supply
As price increases, quantity supplied increases (and vice versa). This is why the supply curve slopes upward.
Supply shifters
Non-price factors that move the entire supply curve. The main ones: number of sellers, technology, cost of production, prices of related goods in production (substitutes and complements in production), and expected future prices.
Substitutes in production
Goods that use the same resources, so producing more of one means less of the other (e.g. using milk to sell as milk versus using it to make ice cream). Negative relationship: when the price of one rises, supply of the other falls.
Complements in production
Goods that are by-products of each other (e.g. cheese and cheese curds). Positive relationship: producing more of one automatically yields more of the other.
Market equilibrium
The price at which quantity demanded equals quantity supplied. Graphically, it is where the demand and supply curves intersect.
Surplus
Occurs when quantity supplied exceeds quantity demanded (price is above equilibrium). Downward pressure on price follows.
Shortage
Occurs when quantity demanded exceeds quantity supplied (price is below equilibrium). Upward pressure on price follows.
The demand-and-supply model rests on four simplifying assumptions: a homogeneous product, many buyers and sellers, perfect information, and a single price.
These assumptions make the model tractable. Real markets deviate from them to varying degrees, but the model still captures the core dynamics well.
The demand curve plots price on the vertical axis and quantity on the horizontal axis.
It slopes downward because of the substitution effect and the income effect.
A market demand curve is the horizontal sum of every individual consumer's willingness to pay. Example from lecture: six consumers with different maximum willingness-to-pay values produce a downward-stepping demand schedule.
A change in price causes movement along the demand curve (a change in quantity demanded).
A change in a non-price factor shifts the entire curve (a change in demand).
When price changes, demand itself does not change; only quantity demanded changes. This distinction is tested heavily.
Number of consumers: more consumers shift demand right (positive).
Income:
Normal goods: income up, demand up (positive).
Inferior goods: income up, demand down (negative).
Prices of related goods:
Substitutes: price of substitute up, demand for this good up (positive).
Complements: price of complement up, demand for this good down (negative).
Expected future price: if consumers expect prices to rise, they buy more now, shifting demand right.
Preferences: changes in tastes or information (e.g. a health warning) shift demand.
The supply curve also plots price on the vertical axis and quantity on the horizontal axis.
It slopes upward for two reasons:
Different firms face different costs, so higher prices draw in producers with higher costs.
Individual firms face increasing marginal costs: producing more units gets progressively more expensive.
Same logic as the demand side. A price change moves along the curve (quantity supplied changes). A non-price factor shifts the entire curve (supply changes).
Number of sellers: more sellers shift supply right (positive).
Technology: better technology shifts supply right (positive), since it lowers costs.
Cost of production: higher costs shift supply left (negative).
Prices of related goods in production:
Substitutes in production: price of the alternative use rises, supply of this good falls (negative).
Complements in production: by-products; producing more of one yields more of the other (positive).
Expected future price: if sellers expect prices to rise, they hold supply back now, shifting current supply left (negative).
Equilibrium is the only price at which there is no pressure for change.
Above equilibrium: surplus forms, sellers compete on price, price falls.
Below equilibrium: shortage forms, buyers bid price up, price rises.
Demand increases (shifts right): equilibrium price rises, equilibrium quantity rises.
Demand decreases (shifts left): equilibrium price falls, equilibrium quantity falls.
Supply increases (shifts right): equilibrium price falls, equilibrium quantity rises.
Supply decreases (shifts left): equilibrium price rises, equilibrium quantity falls.
When both curves shift at the same time, one variable has a determinate direction and the other is ambiguous:
Demand decreases + supply decreases: quantity falls, price is ambiguous.
Demand decreases + supply increases: price falls, quantity is ambiguous.
Demand increases + supply decreases: price rises, quantity is ambiguous.
Demand increases + supply increases: quantity rises, price is ambiguous.
The lecture recommends a three-step approach:
Does the event affect consumers (demand) or sellers (supply)?
Does it make them want to buy/sell more or less?
Draw it out and read the new equilibrium.
No new formulas here beyond the graphical framework. Key diagrams to practise drawing:
A basic demand-and-supply diagram with equilibrium marked.
A demand shift (right or left) with the new equilibrium shown.
A supply shift (right or left) with the new equilibrium shown.
The simultaneous-shift matrix (2x2 table from lecture).
Demand and supply explain price movements you see every day. When a drought raises the cost of wheat (supply shifts left), bread prices rise. When a new streaming platform enters the market (supply of streaming increases), subscription prices tend to fall. When a social-media trend makes a product popular overnight (demand shifts right), the price spikes until supply catches up. The three-step approach from lecture works for analysing any real market event.
Students frequently say "demand increased" when they mean "quantity demanded increased." A price change moves you along the curve; only a non-price factor shifts the curve itself. This error will cost marks.
Another common mistake is thinking that a surplus means the good is "too expensive." A surplus means the current price is above equilibrium, not that the good is overpriced in some absolute sense.
Students sometimes reverse the relationship for inferior goods, thinking income and demand always move together. For inferior goods the relationship is negative: when incomes rise, demand for the inferior good falls.
In simultaneous-shift questions, students often try to give a definite answer for both price and quantity. One of them is always ambiguous unless you know the relative magnitudes of the shifts.
⚠️ The distinction between "a change in demand" (curve shift) and "a change in quantity demanded" (movement along the curve) is one of the most commonly tested points in introductory economics. The same applies on the supply side.
⚠️ Know all five demand shifters and all five supply shifters, including the direction of each relationship.
⚠️ Be able to identify whether a given event shifts demand, supply, or both, and in which direction, then predict the effect on equilibrium price and quantity.
⚠️ For simultaneous shifts, know which variable is determinate and which is ambiguous in all four combinations.
True or false: When the price of a good rises, demand decreases.
Fill in the blank: Hot dogs and buns are examples of ______ goods.
True or false: An improvement in production technology shifts the supply curve to the left.
Fill in the blank: When quantity demanded exceeds quantity supplied, there is a ______.
True or false: If both demand and supply increase simultaneously, the equilibrium quantity definitely rises.
Answers: 1. False (quantity demanded decreases; demand itself does not change). 2. Complementary (complement). 3. False (it shifts supply to the right). 4. Shortage. 5. True (quantity rises; price is ambiguous).
Q: A new health study finds that eating sushi reduces stress. What happens to the market for sushi?
A: This changes consumer preferences, shifting the demand curve for sushi to the right. Equilibrium price and equilibrium quantity both increase.
Q: The price of Thai food falls. What happens in the market for sushi, assuming Thai food and sushi are substitutes?
A: Consumers switch toward the now-cheaper Thai food. Demand for sushi shifts left. Equilibrium price and quantity of sushi both fall.
Q: What is the difference between a substitute in consumption and a substitute in production?
A: A substitute in consumption is an alternative good that buyers might choose instead (Thai food vs. sushi). A substitute in production is an alternative use for the same input from the seller's side (using milk for drinking vs. making ice cream).
Q: Frozen pizza is an inferior good. If consumer incomes fall, what happens in the frozen pizza market?
A: For an inferior good, lower income means higher demand. The demand curve shifts right, so equilibrium price and quantity both rise.
Q: Demand increases and supply decreases at the same time. What can you say about price and quantity?
A: Price definitely rises (both shifts push price up). Quantity is ambiguous (the demand increase pushes quantity up, but the supply decrease pushes it down; the net effect depends on which shift is larger).
Demand and supply underpin every market analysis in the rest of the course: consumer and producer surplus (Part 4), price controls (Part 4), and later topics like aggregate demand and aggregate supply in macroeconomics. The demand shifters reappear when studying the consumption component of GDP. Supply shifters connect to discussions of productivity and costs of production.
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