Source: Textbook Ch. 2 / Lecture Notes
Tags: supply and demand, market equilibrium, price ceiling, price floor, price support, tax burden, tax incidence, deadweight loss, normal goods, inferior goods, substitutes, complements, microeconomic theory, ECON 323, Texas A&M
Chapter 2 covers the core mechanics of how markets work: buyers and sellers interact to establish an equilibrium price and quantity, and when that equilibrium is disrupted (by taxes, price controls, or shifts in demand and supply), predictable consequences follow. Understanding the determinants that shift each curve, and how government intervention redistributes surplus, is the backbone of everything else in micro.
Market
The collection of buyers and sellers who interact to trade a particular good or service. Defining what counts as "the market" (and what sits outside it) matters for any analysis.
Real price
The price of a product measured relative to the prices of other goods and services, rather than in raw dollar terms.
Law of Demand
The empirical observation that when the price of a product falls, people demand larger quantities of it, all else equal.
Law of Supply
The empirical observation that when the price of a product rises, firms offer more of it, all else equal.
Equilibrium (price and quantity)
The price-quantity pair at which both buyers and sellers are satisfied. No pressure exists for the price to move in either direction.
Excess supply (surplus)
The amount by which quantity supplied exceeds quantity demanded. Occurs when price sits above equilibrium.
Excess demand (shortage)
The amount by which quantity demanded exceeds quantity supplied. Occurs when price sits below equilibrium.
Deadweight loss
The value of trades that could have happened at equilibrium but did not. Graphically, it appears to the left of the equilibrium price. Think of it as profit left on the table.
Price ceiling
A legal maximum price for a good. Set below equilibrium, it increases quantity demanded while decreasing quantity supplied, creating a shortage. Rent control is the classic example.
Price floor (price support)
A legal minimum price for a good. Set above equilibrium, it creates excess supply. The government typically commits to buying whatever surplus results.
Rationing function of price
The process by which prices direct existing supplies of a product to the users who value it most highly.
Allocative function of price
The process by which price acts as a signal that guides resources away from the production of goods whose prices lie below cost and towards the production of goods whose prices exceed cost. This matters for the economy as a whole.
Normal good
A good for which the quantity demanded at any price rises when income rises.
Inferior good
A good for which the quantity demanded at any price falls when income rises.
Substitutes
Two goods where an increase in the price of one tends to increase demand for the other (e.g. Coca-Cola and Pepsi).
Complements
Two goods where an increase in the price of one decreases demand for the other (e.g. petrol and cars).
Change in demand
A shift of the entire demand curve (caused by income, tastes, prices of related goods, expectations, population).
Change in quantity demanded
A movement along the existing demand curve, caused only by a change in the good's own price.
At equilibrium, quantity supplied equals quantity demanded and there is no pressure for price to change.
When price is above equilibrium, excess supply exists. Sellers compete to offload surplus, pushing price down.
When price is below equilibrium, excess demand exists. Buyers compete for limited goods, pushing price up.
The adjustment towards equilibrium comes from the natural reactions of self-interested individuals, not from any central coordinator.
Price ceilings (e.g. rent control)
Set below equilibrium to make goods "more affordable."
The unintended result: quantity demanded rises, quantity supplied falls, and a shortage emerges.
Attempting to make goods more affordable can make them less available.
Price floors / price supports
Set above equilibrium to protect sellers (often agricultural producers).
The result: excess supply that the government must typically purchase.
The government is forced to buy whatever surplus the market does not absorb.
Why free markets can still serve the poor
Efficiency arguments hold that even with low incomes, free exchange enables the poor to do the best they can with what they have.
Price controls meant to help can introduce shortages or surpluses that ultimately reduce welfare.
Income: shifts demand right for normal goods, left for inferior goods.
Tastes / preferences: if something becomes more popular, demand shifts right.
Price of substitutes: a price increase in one good raises demand for its substitute.
Price of complements: a price increase in one good lowers demand for its complement.
Expectations: anticipated future prices or income changes can shift current demand.
Population: a larger population means a larger market and higher demand.
Technology: new production methods shift supply right (more output at each price).
Factor prices (input costs): higher input costs shift supply left.
Number of suppliers: more firms in the market shift supply right.
Expectations: anticipated future conditions can shift current supply decisions.
Weather: particularly relevant for agricultural goods; adverse weather shifts supply left.
Seasonal changes: supply (and demand) may shift predictably with the time of year.
A tax drives a wedge between what the buyer pays and what the seller receives.
Buyer's share of the tax burden: the amount the price paid by the buyer increases, measured as a proportion of the total tax.
Seller's share of the tax burden: the amount the price received by the seller decreases, relative to the total tax. Calculated as (pre-tax price minus post-tax seller price) divided by the tax.
The split depends on the relative slopes (elasticities) of supply and demand:
If supply is perfectly inelastic (vertical), the seller bears 100% of the tax.
If supply is perfectly elastic (horizontal), the buyer bears 100% of the tax.
If demand is perfectly inelastic (vertical), the buyer bears 100% of the tax.
A tax levied on the buyer produces the same outcome as the same tax levied on the seller. The statutory incidence (who writes the cheque) does not determine the economic incidence (who actually bears the cost).
Seller's tax burden (as a share):
Seller's share = (P_before − P_seller_receives) / Tax
Buyer's tax burden (as a share):
Buyer's share = (P_buyer_pays − P_before) / Tax
These two shares sum to 1 (or 100%).
Key graphical intuition: draw the supply and demand curves, then insert the tax as a vertical wedge. The steeper (more inelastic) side of the market absorbs the larger share of the tax.
⚠️ Do not confuse a "change in demand" (whole curve shifts) with a "change in quantity demanded" (movement along the curve). This distinction is tested constantly.
⚠️ The statutory side of a tax (buyer vs seller) does not matter for outcomes. The economic incidence depends on relative elasticities. Expect a question that tries to trick you into thinking it matters who the tax is "on."
⚠️ Price ceilings cause shortages, price floors cause surpluses. Keep the direction straight: ceiling = below equilibrium = shortage; floor = above equilibrium = surplus.
⚠️ Deadweight loss sits to the left of equilibrium on the graph. It represents trades that would have been mutually beneficial but did not occur.
⚠️ Know the difference between the rationing function (directing existing supply to highest-value users) and the allocative function (guiding resources toward goods whose prices exceed cost). Both are about prices as signals, but they operate on different margins.
⚠️ Perfectly inelastic supply means the seller absorbs the entire tax. Perfectly elastic supply means the buyer absorbs it. Be ready to identify these on a graph.
Q: What is the difference between a change in demand and a change in quantity demanded?
A: A change in demand is a shift of the entire demand curve, caused by factors like income, tastes, or the price of related goods. A change in quantity demanded is a movement along the existing curve, caused only by a change in the good's own price.
Q: If the government imposes a price ceiling below the equilibrium price, what happens?
A: Quantity demanded increases and quantity supplied decreases, creating a shortage. The good becomes less available despite the intention of making it more affordable.
Q: A tax of £5 is imposed on sellers. Before the tax, equilibrium price was £20. After the tax, buyers pay £23 and sellers receive £18. What is each side's share of the burden?
A: Buyer's share = (23 − 20) / 5 = 60%. Seller's share = (20 − 18) / 5 = 40%.
Q: If supply is perfectly inelastic, who bears the tax?
A: The seller bears 100% of the tax. A vertical supply curve means quantity supplied does not respond to price, so the entire burden falls on the seller.
Q: Name three determinants of supply.
A: Technology, factor prices (input costs), and the number of suppliers. Others include expectations, weather, and seasonal factors.
Q: What is the rationing function of price?
A: It is the process by which prices direct existing supplies of a product to the users who value it most highly. Those willing to pay the market price receive the good; those who are not, do not.
Q: Why does a tax on the buyer produce the same outcome as a tax on the seller?
A: Because the economic incidence depends on the relative elasticities of supply and demand, not on who physically pays the tax. The wedge between buyer price and seller price is the same regardless of which side the tax is levied on.
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