Difficulty: Introductory | Prerequisites: Scarcity, opportunity cost, and marginal analysis (see Part 1 study notes).
Supply and demand is the central model of microeconomics. Nearly every market analysis you encounter, from housing to labour to international trade, comes back to how buyers and sellers interact to determine prices and quantities. This material builds directly on the idea that people respond to incentives: prices are the primary incentive in a market. If you understand how demand and supply curves shift and where equilibrium lands, you have the toolkit for most of what follows in the course.
Demand slopes downward (higher price, less bought); supply slopes upward (higher price, more produced). Where the two curves cross is equilibrium: the price and quantity the market settles on. Anything that shifts either curve changes that equilibrium, and understanding what causes those shifts is the core skill here.
Competitive market
A market with many buyers and sellers, homogeneous (identical) goods, free entry and exit, and price-taking behaviour. Think of it as a market where no single participant is big enough to move the price.
Demand curve
A graph showing the quantity of a good consumers are willing and able to buy at each price, holding all else equal. It slopes downward.
Law of demand
All else equal, a higher price leads to a lower quantity demanded. In simple terms, when things get more expensive, people buy less of them.
Demand schedule
A table listing quantities demanded at different prices. The demand curve is just the graph of this table.
Supply curve
A graph showing the quantity of a good producers are willing and able to sell at each price, holding all else equal. It slopes upward.
Law of supply
All else equal, a higher price leads to a higher quantity supplied. When producers can sell at a higher price, they are willing to make more.
Equilibrium price and quantity
The price at which quantity demanded equals quantity supplied. At this point the market clears: no shortage, no surplus.
Substitutes
Goods that can replace each other. A rise in the price of one increases demand for the other. Think of Coke and Pepsi.
Complements
Goods that are used together. A rise in the price of one decreases demand for the other. Think of printers and ink cartridges.
Normal good
A good for which demand increases when income rises. Most goods are normal goods.
Inferior good
A good for which demand decreases when income rises. Think of instant noodles: as income grows, people switch to something better.
Budget constraint
The set of all combinations of goods a consumer can afford given their income and the prices of those goods.
Relative price
The price of one good expressed in terms of another. It captures the opportunity cost of buying one good instead of the other.
The demand curve is downward-sloping: as price rises, quantity demanded falls
Each point on the curve shows a price-quantity pair, holding everything else constant (ceteris paribus)
The market demand curve is the horizontal sum of all individual demand curves in the market
Movement along the curve (change in quantity demanded): caused by a change in the good's own price
Shift of the entire curve (change in demand): caused by a non-price factor. The whole curve moves left or right
Prices of related goods
Substitutes: if the price of Coke rises, demand for Pepsi shifts right
Complements: if the price of printers rises, demand for ink cartridges shifts left
Consumer income
Normal goods: income up, demand shifts right
Inferior goods: income up, demand shifts left
Tastes and preferences: trends, advertising, seasonal changes (e.g. demand for boots rises in autumn)
Expectations about future prices: if consumers expect prices to rise, they buy more now (demand shifts right); if they expect prices to fall, they wait (demand shifts left)
Number of consumers: more buyers in the market shifts demand right; fewer shifts it left
The supply curve is upward-sloping: as price rises, quantity supplied rises
The supply schedule is the tabular version; the supply curve is the graph
The market supply curve sums individual supply curves across all producers
Input prices: higher costs (wages, raw materials, energy) shift supply left; lower costs shift it right
Prices of related goods in production
Substitutes in production: if the price of wheat rises, a farmer may produce less corn (corn supply shifts left)
Complements in production: if the price of beef rises, the supply of leather (a by-product) also increases
Technology: improvements lower production costs, shifting supply right
Producer expectations: if producers expect higher future prices, they may hold back current supply (shift left) to sell later
Number of producers: more firms entering the market shift supply right; firms exiting shift it left
Equilibrium occurs where the demand and supply curves intersect
At the equilibrium price, quantity demanded = quantity supplied; the market clears
If the price is above equilibrium, a surplus develops (excess supply), pushing the price down
If the price is below equilibrium, a shortage develops (excess demand), pushing the price up
Market forces naturally push prices toward equilibrium
The budget constraint shows all combinations of two goods a consumer can afford: PxX + PyY = I
Rearranging into slope-intercept form: Y = (I/Py) – (Px/Py) × X
The slope of the budget line is –Px/Py, which is the relative price of good X in terms of good Y
The relative price tells you the opportunity cost of one more unit of X: how much Y you must give up
A change in income shifts the budget line (parallel shift); a change in one good's price rotates it
Budget constraint (standard form):
P_X \cdot X + P_Y \cdot Y = IBudget constraint (slope-intercept form):
Y = \frac{I}{P_Y} - \frac{P_X}{P_Y} \cdot XThe slope of the budget line is –Px/Py, representing the relative price of X in terms of Y.
Equilibrium condition:
Q_D = Q_SAt equilibrium, quantity demanded equals quantity supplied. Solve by setting the demand and supply equations equal and solving for price.
Petrol prices: when oil input costs rise, the supply of petrol shifts left, pushing the price up and quantity down. This is a supply shift, not a demand shift.
Housing markets: population growth (more consumers) shifts housing demand right, raising prices. New construction shifts supply right, moderating the increase.
Budget constraints in daily life: your monthly income and the prices of food vs. entertainment define your budget line. A pay rise shifts it outward; a rent increase rotates it inward.
Students often confuse a shift of the demand curve (the whole curve moves) with a movement along it (price changes, you slide along the existing curve). A price change for the good itself causes movement along; everything else shifts the curve.
A similar confusion applies to supply. A change in the good's own price is movement along; changes in input costs, technology, or expectations shift the curve.
Students sometimes think equilibrium means the market is "frozen." It means there is no pressure to change, not that nothing ever changes. A new shock shifts a curve and creates a new equilibrium.
Many students mix up substitutes and complements. Test: if the price of A rises, does demand for B go up (substitutes) or down (complements)?
⚠️ "Shift vs. movement" is one of the most frequently tested distinctions. If the question says "the price of the good changes," that is movement along the curve. Anything else is a shift.
⚠️ Know the five demand shifters and the five supply shifters cold. Exam questions often describe a scenario and ask you to identify which curve shifts, and in which direction.
⚠️ Equilibrium problems are standard: given demand and supply equations, solve for price and quantity. Then apply a shock (a tax, a cost change) and find the new equilibrium.
⚠️ Budget constraint algebra appears in problem sets. Be ready to calculate the slope, identify relative prices, and explain what happens when income or a price changes.
⚠️ Substitutes vs. complements in both consumption and production are commonly tested. Production substitutes and complements are less intuitive, so give them extra attention.
True or false: A rise in the price of a good causes a shift of its demand curve. (False – it causes a movement along the curve.)
Fill in the blank: If two goods are complements, a rise in the price of one causes demand for the other to ______. (Decrease / shift left.)
True or false: Improvements in technology shift the supply curve to the left. (False – they shift it to the right by reducing costs.)
Fill in the blank: At equilibrium, quantity demanded ______ quantity supplied. (Equals.)
True or false: Instant noodles are likely a normal good. (False – they are typically an inferior good, since demand falls as income rises.)
Q: The price of coffee rises. What happens to the demand for tea, and why?
A: Tea and coffee are substitutes. A rise in coffee's price makes consumers switch to tea, shifting the demand curve for tea to the right.
Q: A new technology reduces the cost of producing smartphones. Show the effect on the smartphone market using supply and demand analysis.
A: Lower production costs shift the supply curve to the right. At the original equilibrium price, there is now a surplus, which pushes the price down. The new equilibrium has a lower price and higher quantity.
Q: A consumer has income I = £200, Px = £10, Py = £20. Write the budget constraint and calculate its slope.
A: Budget constraint: 10X + 20Y = 200. Slope-intercept form: Y = 10 – 0.5X. The slope is –0.5, meaning the consumer must give up 0.5 units of Y for each additional unit of X.
Q: Explain why a surplus causes the price to fall.
A: When price is above equilibrium, quantity supplied exceeds quantity demanded. Producers cannot sell all their output, so they lower prices to attract buyers. This continues until quantity demanded equals quantity supplied at the new, lower price.
Q: The government announces that petrol taxes will rise next month. What happens to current demand for petrol?
A: Consumers expect the future price to be higher, so they buy more now to avoid the tax increase. Current demand shifts right.
Supply and demand underpins nearly everything that follows. Elasticity (Part 3 notes) measures how responsive demand and supply are to price changes. Price controls (ceilings and floors) are interventions that force the market away from equilibrium, creating shortages or surpluses. Consumer and producer surplus, covered in welfare economics, are areas on the supply-demand diagram. The budget constraint connects directly to consumer choice theory and indifference curves.
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