Difficulty: Intermediate | Prerequisites: Introductory microeconomics (principles of economics), basic calculus (derivatives, partial derivatives).
Supply, demand, and elasticity form the backbone of intermediate micro. Every later topic in the course, from consumer theory to market structure, builds on how prices emerge from the interaction of buyers and sellers, and on how sensitively agents respond to price changes. If you are coming in cold, this is the place to start: without a firm grip on equilibrium and elasticity, the optimisation problems and welfare analysis that follow will feel like they come out of nowhere. You should already be comfortable with basic supply-and-demand diagrams from introductory economics, and with taking simple derivatives.
Markets reach equilibrium where the quantity buyers want equals the quantity sellers offer. Any change in price moves you along a curve; any change in another factor (income, input costs, tastes) shifts the entire curve. Elasticity measures how strongly quantity responds to a change in price, income, or the price of a related good, and it determines who bears the burden of a tax, how revenue changes with price, and how much market power a firm can exercise.
Positive analysis
Describes how the economy works using cause-and-effect statements that can be tested against data. In simple terms, it answers "what is" rather than "what should be."
Normative analysis
Value judgements about what policies or outcomes ought to be pursued. Think of it as the "should" side of economics, where opinions and ethics come in.
Efficiency (Pareto efficiency)
An allocation where no one can be made better off without making someone else worse off. In simple terms, there is no free improvement left on the table.
Equity
Fairness in the distribution of income, wealth, and opportunities across society. Efficiency and equity often pull in opposite directions.
Supply
The total quantity of a good that producers are willing and able to sell at each price. Think of it as the sellers' side of the market.
Demand
The total quantity of a good that consumers are willing and able to buy at each price. This is the buyers' side.
Market equilibrium
The price and quantity at which quantity supplied equals quantity demanded. No shortages, no surpluses: the market clears.
Demand curve
A downward-sloping curve showing the inverse relationship between a good's own price and the quantity demanded, holding all else constant.
Supply curve
An upward-sloping curve showing that higher prices induce greater quantity supplied, holding all else constant.
Price elasticity of demand (E_P)
The percentage change in quantity demanded divided by the percentage change in price. It tells you how responsive buyers are to price movements.
Price elasticity of supply (E_S)
The percentage change in quantity supplied divided by the percentage change in price. Measures how flexibly producers respond.
Income elasticity of demand
The percentage change in quantity demanded divided by the percentage change in consumer income. Positive for normal goods, negative for inferior goods.
Cross-price elasticity of demand
The percentage change in the quantity demanded of one good divided by the percentage change in the price of another good. Positive for substitutes, negative for complements, zero for unrelated goods.
Normal good
A good whose demand increases when income rises. Income elasticity is positive.
Inferior good
A good whose demand falls when income rises. Income elasticity is negative. Think of instant noodles giving way to restaurant meals as a student's budget grows.
Substitutes
Goods that can replace each other in consumption. A rise in the price of one increases demand for the other.
Complements
Goods consumed together. A rise in the price of one decreases demand for the other.
Markets and equilibrium
A market is defined by a good or service, a location, and a time period. Supply and demand together determine the equilibrium price and quantity.
Equilibrium occurs where Q_D(P) = Q_S(P). At this point, willingness to pay equals willingness to accept, and there are no shortages or surpluses.
Demand curve and its determinants
The demand curve slopes downward: as own price falls, quantity demanded rises.
Determinants beyond own price: prices of related goods (substitutes and complements), consumer income, tastes and preferences, expectations about future prices, and the number of consumers.
The general demand function: Q_D = Q(P, P_related, Income, Tastes, Expectations, Number of consumers).
Example: when the price of a substitute rises, demand for this good shifts outward (rightward).
Supply curve and its determinants
The supply curve slopes upward: higher prices incentivise producers to supply more.
Determinants beyond own price: input costs, technology, weather, expectations, and the number of suppliers.
The general supply function: Q_S = Q(P, R, Technology, Weather, Expectations, Number of suppliers).
Movement along vs. shift of curves
A change in the good's own price causes movement along the curve (a change in quantity demanded or supplied).
A change in any other determinant causes the entire curve to shift (a change in demand or supply at every price).
This distinction is one of the most commonly tested points in the course. Mixing up "a change in demand" with "a change in quantity demanded" is a reliable way to lose marks.
Assumptions of the supply and demand model
Many buyers and sellers (perfect competition)
Price-taking behaviour (no individual can influence the market price)
Homogeneous goods
Perfect information
Private, rivalrous goods
These assumptions create an idealised benchmark. Much of the rest of the course explores what happens when one or more of them is relaxed.
Positive vs. normative analysis
Positive analysis: factual, testable claims about how the economy works. "An increase in demand raises the equilibrium price."
Normative analysis: value judgements about what policies should be. "The government should raise taxes to reduce inequality."
Keeping these separate matters because positive analysis can be checked against data; normative claims cannot.
Efficiency vs. equity
Efficiency (Pareto): can we improve someone's welfare without harming anyone else?
Equity: how fairly are resources distributed?
Policies that improve one often come at the cost of the other. This trade-off runs through the entire course.
Elasticity measures responsiveness as a percentage change in one variable divided by a percentage change in another. Because it is unit-free, you can compare elasticities across completely different goods and markets.
Price elasticity of demand
Defined as: E_P = (% change in Q_D) / (% change in P).
Typically negative (downward-sloping demand), but often reported as an absolute value.
|E_P| > 1: elastic demand. Buyers are sensitive to price. A price increase reduces total revenue.
|E_P| < 1: inelastic demand. Buyers are relatively unresponsive. A price increase raises total revenue.
|E_P| = 1: unit elastic. Total revenue is at its maximum.
Elasticity also determines tax incidence: the more inelastic side of the market bears a larger share of the tax burden.
Firms with less elastic demand can charge higher markups (more market power).
Price elasticity of supply
Defined as: E_S = (% change in Q_S) / (% change in P).
Depends on production flexibility and input substitutability.
A firm that can easily ramp production up or down has high supply elasticity.
Income elasticity of demand
Positive for normal goods (demand rises with income).
Negative for inferior goods (demand falls as income rises).
Greater than 1: luxury good (demand grows faster than income).
Between 0 and 1: necessity (demand grows, but more slowly than income).
Cross-price elasticity of demand
Positive: the two goods are substitutes (a rise in the price of one increases demand for the other).
Negative: the two goods are complements (a rise in the price of one decreases demand for the other).
Zero: the goods are unrelated.
Equilibrium condition
Q_D(P) = Q_S(P)
Solve for P to find the equilibrium price, then substitute back for the equilibrium quantity.
Price elasticity of demand
E_P = (% change in Q_D) / (% change in P) = (dQ/dP) x (P/Q)
Price elasticity of supply
E_S = (% change in Q_S) / (% change in P) = (dQ_S/dP) x (P/Q_S)
Income elasticity
E_I = (% change in Q_D) / (% change in Income) = (dQ/dI) x (I/Q)
Cross-price elasticity
E_XY = (% change in Q_X) / (% change in P_Y) = (dQ_X/dP_Y) x (P_Y/Q_X)
Demand function (general form)
Q_D = Q(P, P_related, Income, Tastes, Expectations, Number of consumers)
Supply function (general form)
Q_S = Q(P, R, Technology, Weather, Expectations, Number of suppliers)
Elasticity is why petrol prices spike sharply when supply drops: both supply and demand for fuel are inelastic in the short run, so even a small supply disruption produces large price swings. Tax incidence analysis uses elasticity to predict that, for instance, a cigarette tax falls mostly on smokers (inelastic demand) rather than on tobacco companies.
Students often confuse a "change in demand" (the whole curve shifts) with a "change in quantity demanded" (movement along the curve). A price change causes the latter, not the former.
Students sometimes treat elasticity as the same thing as slope. Elasticity varies along a straight-line demand curve even though the slope is constant.
A common error is to assume that an inelastic good has perfectly vertical demand. Inelastic simply means |E| < 1; the curve still slopes downward.
Students often forget that the equilibrium model assumes perfect competition. Applying its conclusions directly to monopoly or oligopoly markets leads to wrong answers.
⚠️ The movement-vs.-shift distinction appears on nearly every exam. If a question says "the price of an input rises," that shifts the supply curve; if it says "the price of the good rises," that is movement along the demand curve.
⚠️ Be ready to calculate equilibrium price and quantity from given linear supply and demand equations, and to show what happens when one curve shifts.
⚠️ Know how to determine whether demand is elastic or inelastic at a given point, and what that implies for total revenue.
⚠️ Exam questions frequently ask you to identify whether two goods are substitutes or complements from a cross-price elasticity value.
True or false: A fall in the price of coffee (a complement to sugar) shifts the demand curve for sugar to the right. (True.)
Fill in the blank: When |E_P| > 1, demand is _______ and a price increase will _______ total revenue. (elastic; reduce)
True or false: A technological improvement in production shifts the demand curve to the right. (False. It shifts the supply curve to the right.)
Fill in the blank: Income elasticity is negative for _______ goods. (inferior)
True or false: At market equilibrium, every consumer who wants the good at that price can buy it. (True.)
Q: Suppose the demand for a good is Q_D = 100 - 2P and the supply is Q_S = 3P - 25. Find the equilibrium price and quantity.
A: Set Q_D = Q_S: 100 - 2P = 3P - 25. Solving: 125 = 5P, so P = 25. Substituting back: Q = 100 - 2(25) = 50.
Q: If a 10% increase in the price of butter causes a 5% increase in the quantity demanded of margarine, what is the cross-price elasticity, and what does it tell you about the relationship between the two goods?
A: Cross-price elasticity = 5% / 10% = 0.5. The positive sign means butter and margarine are substitutes.
Q: A firm faces inelastic demand for its product. Should it raise or lower the price to increase total revenue, and why?
A: Raise the price. With inelastic demand (|E_P| < 1), the percentage fall in quantity is smaller than the percentage rise in price, so total revenue (P x Q) increases.
Q: Explain why a tax on a good with perfectly inelastic demand falls entirely on consumers.
A: Perfectly inelastic demand means quantity demanded does not change when the price changes. Producers can pass the full tax through to the price, and consumers continue to buy the same quantity. The supply curve shifts up by the tax amount, but the equilibrium quantity does not change, so the entire burden rests on buyers.
Q: The government imposes a price ceiling below the equilibrium price. What happens in the market?
A: At the ceiling price, quantity demanded exceeds quantity supplied, creating a shortage. The market does not clear; some willing buyers cannot purchase the good.
Elasticity feeds directly into consumer theory: the price elasticity of demand is derived from utility maximisation and the shape of indifference curves. It also underpins the analysis of monopoly pricing, where the Lerner Index links a firm's markup to the inverse of demand elasticity. The supply side connects to production theory and cost curves, which determine how flexibly firms respond to price signals.
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