Difficulty: Intermediate | Prerequisites: Foundations of Economics notes, Production and Trade notes
Tags: supply, demand, law of supply, law of demand, equilibrium, surplus, shortage, consumer surplus, producer surplus, total surplus, deadweight loss, price ceiling, price floor, perfect competition, break even, minimum wage, shifts, movements
This is the most heavily tested section of Exam 1. Supply and demand analysis is the workhorse model of microeconomics, and virtually every later topic builds on it. You need to be fluent in drawing and interpreting supply and demand diagrams, calculating surplus, and predicting the effects of price controls. If you can solve equilibrium problems and surplus calculations quickly and accurately, you are well prepared for the exam.
Market equilibrium occurs where quantity supplied equals quantity demanded. Consumer surplus is the difference between willingness to pay and the market price; producer surplus is the difference between market price and the seller's cost. Price controls (ceilings and floors) that are set away from equilibrium create shortages or surpluses and reduce total welfare.
Law of demand
As the price of a good rises, the quantity demanded falls (and vice versa), all else being equal. This gives the demand curve its downward slope. In simple terms, when something gets more expensive, people buy less of it.
Law of supply
As the price of a good rises, the quantity supplied rises (and vice versa), all else being equal. This gives the supply curve its upward slope. In simple terms, higher prices make production more profitable, so firms supply more.
Equilibrium
The point where quantity supplied equals quantity demanded (QS = QD). At this price, there is no tendency for the market to change. No surplus, no shortage.
Shortage
Occurs when quantity demanded exceeds quantity supplied (QD > QS). This happens when the price is below the equilibrium price. Note: there is generally no shortage of most scarce goods in a market economy, because the price adjusts.
Surplus (market surplus)
Occurs when quantity supplied exceeds quantity demanded (QS > QD). This happens when the price is above the equilibrium price.
Shifts vs movements
A movement is along a curve, caused by a change in the good's own price. A shift is of the entire curve, caused by a change in a non-price determinant (income, tastes, expectations, number of buyers/sellers, prices of related goods, input costs, technology). Shifts involve the whole curve relocating; movements are slides along the existing curve.
Consumer surplus (CS)
The difference between what a consumer is willing to pay (WTP) and the price they actually pay. CS = WTP - P. Graphically, it is the area below the demand curve and above the market price.
Producer surplus (PS)
The difference between the price a seller receives and their cost of production. PS = P - C. Graphically, it is the area above the supply curve and below the market price.
Total (economic) surplus
Consumer surplus plus producer surplus. TS = CS + PS. At competitive equilibrium, total surplus is maximised and deadweight loss is zero.
Deadweight loss
The loss in total surplus that occurs when a market is not at competitive equilibrium, for example due to a price control or a tax. It represents transactions that would have been mutually beneficial but do not happen.
Price ceiling
A legal maximum price set below the equilibrium price. It causes a shortage because QD > QS at the lower price. Example: rent control.
Price floor
A legal minimum price set above the equilibrium price. It causes a surplus because QS > QD at the higher price. Example: minimum wage.
Break even
The point where total revenue equals total cost, so profit is zero. A firm at break even is covering all its costs, including opportunity costs, but earning no economic profit.
Perfect competition
A market structure characterised by many buyers and sellers, no barriers to entry, and homogeneous (identical) goods. No single buyer or seller can influence the market price.
The law of demand says price up, quantity demanded down (P↑ → QD↓) and price down, quantity demanded up (P↓ → QD↑). The law of supply says price up, quantity supplied up (P↑ → QS↑) and price down, quantity supplied down (P↓ → QS↓).
Movement along the curve: Caused by a change in the good's own price. You slide along the existing demand or supply curve.
Shift of the curve: Caused by a change in a non-price determinant. The entire curve relocates left or right.
Demand shifters include income, tastes and preferences, prices of related goods (substitutes and complements), expectations, and the number of buyers. Supply shifters include input costs, technology, expectations, and the number of sellers.
When both curves shift simultaneously, one variable (P or Q) can usually be determined, while the other is ambiguous:
Demand unchanged, supply shifts right: Q increases, P decreases.
Demand unchanged, supply shifts left: Q decreases, P increases.
Demand shifts right, supply unchanged: Q increases, P increases.
Demand shifts left, supply unchanged: Q decreases, P decreases.
Both shift right: Q increases, P is ambiguous.
Both shift left: Q decreases, P is ambiguous.
Demand right, supply left: P increases, Q is ambiguous.
Demand left, supply right: P decreases, Q is ambiguous.
Price ceiling (set below equilibrium): Creates a shortage. Quantity demanded exceeds quantity supplied at the artificially low price. Example: rent controls keep housing prices low but reduce the quantity of housing supplied.
Price floor (set above equilibrium): Creates a surplus. Quantity supplied exceeds quantity demanded at the artificially high price. Example: a minimum wage set above the equilibrium wage leads to more workers seeking jobs than firms are willing to hire, creating unemployment.
A price ceiling above equilibrium or a price floor below equilibrium is not binding (not effective) and has no impact on the market.
At competitive equilibrium, the market maximises total surplus. Using the textbook's labelled diagram (price of $2.20 and $2.00 with quantity at 14,000 and 15,000 cups per day):
Consumer surplus = area A + B + C (the triangle below the demand curve and above the equilibrium price).
Producer surplus = area D + E (the triangle above the supply curve and below the equilibrium price).
Deadweight loss = none at competitive equilibrium.
A perfectly competitive market has three defining features:
Many buyers and sellers, none large enough to influence the price.
No barriers to entry or exit.
Homogeneous (identical) products.
In perfect competition, firms are price takers. The market price is determined by the intersection of market supply and market demand.
Minimum wage laws are the most commonly cited example of a price floor. When set above the equilibrium wage, they can lead to higher unemployment among low-skilled workers, because firms reduce the quantity of labour demanded. This is the "more workers will be unable to find jobs" result from the source material.
Consumer Surplus: CS = WTP - P (willingness to pay minus the price actually paid)
Producer Surplus: PS = P - C (price received minus the cost of providing the good)
Total / Economic Surplus: TS = CS + PS
Surplus areas on a standard supply-demand diagram are triangles. The formula for each is:
Area = 0.5 x base x height
For consumer surplus, the base is the equilibrium quantity and the height is the distance from the equilibrium price to the demand curve's vertical intercept (the highest price anyone would pay). For producer surplus, the base is the equilibrium quantity and the height is the distance from the supply curve's vertical intercept to the equilibrium price.
Students confuse shifts and movements constantly. A change in the good's own price causes a movement along the curve. A change in anything else (income, tastes, input costs, technology) shifts the entire curve. If you write "the demand curve moved because the price changed," you have made the single most common error on this exam.
A price ceiling above the equilibrium price has no effect. Only a ceiling below equilibrium is binding and creates a shortage. The same logic applies to price floors: only a floor above equilibrium is binding and creates a surplus.
Deadweight loss is zero at competitive equilibrium. Students sometimes assume there is always deadweight loss. There is only deadweight loss when the market is prevented from reaching equilibrium.
"Surplus" in the market surplus sense (QS > QD) is different from "consumer surplus" or "producer surplus" (welfare measures). Do not confuse the two uses of the word.
⚠️ Shifts vs movements is the most commonly tested distinction. Be precise.
⚠️ Be able to calculate consumer surplus, producer surplus, and total surplus from a supply-demand diagram.
⚠️ Know the effects of price ceilings (shortage) and price floors (surplus), and be able to identify when a control is binding vs non-binding.
⚠️ The supply-demand shift matrix (what happens to P and Q when both curves shift) is a common exam question. Memorise which variable is ambiguous in each case.
⚠️ Know the three conditions for perfect competition and be able to explain why each matters.
⚠️ Understand that an effective minimum wage above equilibrium causes unemployment (more workers seeking jobs than firms will hire).
True or False: A decrease in the price of a good causes the demand curve to shift to the right.
False. A decrease in the good's own price causes a movement along the demand curve (quantity demanded increases), not a shift.
Fill in the blank: At equilibrium, QS ______ QD.
Equals (QS = QD).
True or False: A price floor set below the equilibrium price creates a surplus.
False. A floor below equilibrium is not binding and has no effect. Only a floor above equilibrium creates a surplus.
Fill in the blank: Consumer surplus = ______ minus ______.
Willingness to pay (WTP) minus price (P).
True or False: In a perfectly competitive market, a single firm can set the price.
False. In perfect competition, firms are price takers.
Q: The price of coffee beans (an input for coffee shops) increases. What happens to the supply curve for brewed coffee, and what is the effect on equilibrium price and quantity?
A: The supply curve for brewed coffee shifts to the left (decrease in supply) because input costs have risen. Equilibrium price increases and equilibrium quantity decreases.
Q: A city imposes a rent ceiling of $800/month in a market where the equilibrium rent is $1,200/month. What happens?
A: The ceiling is binding because it is below the equilibrium price. At $800, quantity demanded for apartments exceeds quantity supplied, creating a housing shortage. Some people who want apartments at $800 cannot find them.
Q: Both demand and supply for a good increase simultaneously. What can you say about the equilibrium price and quantity?
A: Equilibrium quantity definitely increases (both shifts push Q up). Equilibrium price is ambiguous: demand shifting right pushes price up, while supply shifting right pushes price down. The net effect on price depends on the relative magnitudes of the shifts.
Q: At competitive equilibrium, consumer surplus is A + B + C and producer surplus is D + E. A price ceiling is imposed. What area represents the deadweight loss?
A: The deadweight loss is the area of the triangle formed by the transactions that no longer occur, the region between the supply and demand curves from the new (lower) quantity to the equilibrium quantity. The specific letter labels depend on the diagram, but the concept is that total surplus shrinks by this triangle.
Q: Why is there generally no shortage of most scarce goods in a market economy?
A: Because the price mechanism adjusts. When a good becomes scarcer, its price rises, which reduces quantity demanded and increases quantity supplied until a new equilibrium is reached. Shortages persist only when prices are prevented from adjusting (e.g. by a price ceiling).
Supply and demand analysis is the foundation for every market structure you will study later (monopoly, oligopoly, monopolistic competition). Consumer and producer surplus reappear in welfare analysis, taxation (where taxes create deadweight loss in the same way price controls do), and international trade (where tariffs act as a form of price control). The concept of equilibrium extends to factor markets (labour, capital) and financial markets.
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