Difficulty: Introductory | Prerequisites: Opportunity Cost and PPF notes
Supply and demand is the central framework for understanding how prices are determined in a market economy. This material builds directly on opportunity cost and feeds into market equilibrium, consumer and producer surplus, and government intervention. If you can identify what shifts a curve versus what moves along a curve, you are halfway to the exam.
Demand slopes downward (higher price, less bought) and supply slopes upward (higher price, more offered). Changes in a good's own price move you along the curve. Changes in anything else (income, input costs, tastes, related goods, expectations, technology) shift the whole curve to a new position.
Law of demand
As the price of a good rises, the quantity demanded falls; as the price falls, the quantity demanded rises (all else equal). The demand curve slopes downward.
Law of supply
As the price of a good rises, the quantity supplied rises; as the price falls, the quantity supplied falls (all else equal). The supply curve slopes upward.
Demand
The entire relationship between a good's price and the quantity consumers want to buy, represented by the demand curve as a whole.
In simple terms, this means: the full schedule or curve, not a single number.
Quantity demanded
The specific amount consumers want to buy at one particular price. A single point on the demand curve.
Think of it as: one reading off the curve at a given price.
Supply
The entire relationship between a good's price and the quantity producers are willing to sell, represented by the supply curve as a whole.
Quantity supplied
The specific amount producers are willing to sell at one particular price. A single point on the supply curve.
Normal good
A good for which demand increases when consumer income rises and decreases when income falls. Most goods are normal goods.
Think of it as: you buy more of it when you have more money. Eggs, restaurant meals, new clothes.
Inferior good
A good for which demand decreases when consumer income rises and increases when income falls.
Think of it as: you buy less of it when you have more money because you switch to something better. Instant ramen noodles, bus tickets when you can afford a car.
Substitutes (in consumption)
Two goods that serve a similar purpose, so consumers purchase one instead of the other. When the price of one rises, demand for the other increases.
Example: French fries and tater tots, or concert tickets for two similar artists.
Complements (in consumption)
Two goods that consumers tend to buy together. When the price of one rises, demand for the other falls.
Example: video game controllers and headsets, or hot dogs and hot dog buns.
Substitutes in production
Two goods a firm could produce with the same resources. If the price of one rises, the firm shifts resources toward it, and the supply of the other falls.
Example: a dairy farm can use milk to make butter or cream. If the price of cream rises, butter supply falls.
Complements in production
Two goods that are produced together as a joint output. If the price of one rises and more of it is produced, the supply of the other also increases.
Example: bread and cheese produced for grilled cheese sandwiches, or beef and leather.
Price is on the vertical axis (y), quantity on the horizontal axis (x).
The curve slopes downward: higher price = lower quantity demanded.
A change in the good's own price causes a movement along the demand curve (a change in quantity demanded).
A change in anything other than the good's own price causes the whole demand curve to shift (a change in demand).
Consumer income
Normal good: income rises, demand increases (shifts right). Income falls, demand decreases (shifts left).
Inferior good: income rises, demand decreases (shifts left). Income falls, demand increases (shifts right).
Example: ramen noodles are an inferior good. When consumers' income falls, demand for ramen increases and the demand curve shifts right.
Prices of related goods
Substitutes (+): price of one rises, demand for the other increases. If the price of French fries rises, demand for tater tots increases.
Complements (-): price of one rises, demand for the other falls. If the price of a game controller rises, demand for headsets falls.
Expected future prices
If consumers expect the price to rise soon, they buy more now (demand shifts right).
Example: if petrol prices are expected to rise on Wednesday, people fill up on Monday or Tuesday.
Preferences and tastes
A change in what consumers want. If people learn that smoking causes lung cancer, demand for cigarettes falls (shifts left).
The curve slopes upward: higher price = higher quantity supplied.
A change in the good's own price causes a movement along the supply curve (a change in quantity supplied).
A change in anything other than the good's own price causes the whole supply curve to shift (a change in supply).
Cost of production / price of inputs (-)
If input costs rise, supply decreases (shifts left). If input costs fall, supply increases (shifts right).
Example: if the price of cheese (an input for cheeseburgers) rises, the supply of cheeseburgers decreases.
Prices of related goods in production
Substitutes in production (-): if the price of cream rises, firms use more milk for cream and less for butter. Supply of butter falls.
Complements in production (+): if the price of bread rises and more bread is produced, the supply of cheese (a joint product) also rises.
Other supply shifters include technology (better tech shifts supply right), number of sellers (more sellers shifts supply right), and expectations about future prices.
This is the single most important concept to internalise in this unit.
Change in demand or change in supply = the whole curve shifts to a new position. Caused by a non-price factor (a demand shifter or supply shifter).
Change in quantity demanded or change in quantity supplied = movement along the existing curve. Caused only by a change in the good's own price.
Petrol prices are a textbook example of supply and demand at work: when oil-producing countries cut output (supply shifts left), prices at the pump rise. The distinction between substitutes and complements shows up in everyday pricing decisions, such as why streaming services drop prices when a competitor launches (substitutes) or why printer companies sell printers cheaply but charge more for ink cartridges (complements).
Students often say "demand increased" when they mean "quantity demanded increased." These are different things. Demand increases means the whole curve shifted. Quantity demanded increases means you moved along the existing curve because the price changed.
Students confuse the sign on substitutes and complements. Substitutes have a positive cross-effect (price of A up, demand for B up). Complements have a negative cross-effect (price of A up, demand for B down).
Students sometimes think supply and demand curves only shift to the right. Both can shift in either direction. A demand decrease shifts the curve left; a supply decrease also shifts the curve left.
Students sometimes forget that a change in the good's own price never shifts its own curve. It can only cause a movement along the curve.
⚠️ The shift-versus-movement distinction is the most commonly tested concept in this unit. If a question describes a change in the good's own price, the answer involves movement along the curve. If a question describes a change in anything else, the answer involves a shift of the curve.
⚠️ Know how to identify whether an event affects consumers (demand side) or sellers (supply side), and which direction the curve shifts.
⚠️ Be able to classify a good as normal or inferior from a description of how demand responds to income changes.
⚠️ Substitutes in consumption versus substitutes in production are different concepts. Make sure you know which applies in a given question.
True or False: A rise in the price of a good causes its demand curve to shift left.
False. A rise in the good's own price causes a movement along the demand curve (decrease in quantity demanded), not a shift of the curve.
Fill in the blank: If consumer income rises and demand for a good falls, that good is a(n) ______ good.
Inferior.
True or False: Substitutes in consumption have a positive cross-price effect.
True. Price of one rises, demand for the other rises.
Fill in the blank: A change in ______ shifts the supply curve, while a change in the good's own ______ causes movement along it.
A non-price factor (such as input costs or technology); price.
True or False: When two goods are complements, a rise in the price of one leads to an increase in demand for the other.
False. A rise in the price of one complement leads to a decrease in demand for the other.
Q: The price of Lady Gaga concert tickets falls. Lady Gaga tickets and Ariana Grande tickets are substitutes. What happens to the demand curve for Ariana Grande tickets?
A: The demand curve for Ariana Grande tickets shifts to the left (demand decreases), because consumers switch to the now-cheaper substitute.
Q: The price of rice, an input used to make paella, rises. What happens to the supply curve for paella?
A: The supply curve for paella shifts to the left (supply decreases), because the cost of production has risen.
Q: Cheese and curds are complements in production. The price of cheese rises. What happens to the supply of curds?
A: The supply of curds increases (supply curve shifts right). Because cheese and curds are produced together, higher cheese prices lead to more cheese production, which also produces more curds.
Q: Ramen noodles are an inferior good. Consumer income falls. What happens to the demand for ramen and the equilibrium price?
A: Demand for ramen increases (demand curve shifts right), which raises both the equilibrium price and the equilibrium quantity.
Q: A question asks, "If the price of oranges rises, what happens to the demand for oranges?" What is the correct answer?
A: Nothing happens to demand. Demand (the whole curve) does not change. What changes is the quantity demanded, which decreases as you move along the existing demand curve. This is a classic trick question.
Supply and demand feed directly into market equilibrium (the next topic): once you know how curves shift, you can predict what happens to the equilibrium price and quantity. Consumer and producer surplus are measured using the areas between the supply and demand curves and the market price. Government price controls (ceilings and floors) only make sense once you understand what equilibrium looks like and how markets naturally adjust.
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