Difficulty: Introductory to Intermediate | Prerequisites: None (foundational topic)
This is the bedrock of intermediate microeconomics. Every market structure you study later (monopoly, oligopoly, perfect competition) rests on understanding how supply curves, demand curves, and equilibrium interact. If you have been away from the material for a few weeks, start here: the concepts of shifts, movements along curves, elasticity, and surplus recur throughout the course. You should already be comfortable reading a basic price-quantity graph.
Supply and demand curves describe how much buyers want and sellers offer at each price. Where they cross is the equilibrium, the price and quantity the market settles on when left alone. Anything that shifts either curve (a frost, a change in the price of a substitute, a new regulation) moves that equilibrium, and price controls that force the market away from it create shortages, surpluses, or deadweight loss.
Microeconomics
The study of how individual households and firms make decisions and interact in markets. In simple terms, this means zooming in on specific markets and agents rather than the economy as a whole (that is macroeconomics).
Opportunity cost
The highest-valued alternative that must be given up when you choose one activity over another. Think of it as the "real price" of any decision: what you sacrifice, not just what you spend.
Law of demand
All else equal, when the price of a good rises, the quantity demanded falls, and vice versa. This is a movement along the demand curve, not a shift of it.
Demand curve shift (rightward or leftward)
A change in any non-price factor (income, tastes, price of substitutes or complements, expectations) moves the entire demand curve. A rightward shift means consumers want more at every price.
Supply curve shift (leftward or rightward)
A change in production conditions (input costs, technology, weather, regulation) moves the entire supply curve. A leftward shift means producers supply less at every price.
Equilibrium price and quantity
The price and quantity where the supply curve and demand curve intersect. At this point, quantity supplied equals quantity demanded, and there is no pressure for the price to change.
Shortage
Occurs when the market price is below equilibrium, so quantity demanded exceeds quantity supplied. Buyers compete for the limited goods, pushing the price upward.
Surplus
Occurs when the market price is above equilibrium, so quantity supplied exceeds quantity demanded. Sellers compete for buyers, pushing the price downward.
Choke price
The price at which quantity demanded falls to zero. Found by setting Q = 0 in the demand equation and solving for P.
Price elasticity of demand (PED)
A measure of how responsive quantity demanded is to a change in price. Calculated as (dQ/dP) x (P/Q). The result is typically negative because demand slopes downward.
Elastic demand
When the absolute value of PED is greater than 1. Quantity demanded is highly responsive to price changes. A small price increase causes a proportionally larger drop in quantity demanded.
Inelastic demand
When the absolute value of PED is less than 1. Quantity demanded is not very responsive to price changes.
Consumer surplus (CS)
The difference between what consumers are willing to pay for a good and what they actually pay. Graphically, it is the area below the demand curve and above the market price.
Producer surplus (PS)
The difference between the market price and the cost of production. Graphically, it is the area above the supply curve and below the market price.
Deadweight loss (DWL)
The loss in total surplus that occurs when a market is not at the efficient equilibrium. It represents mutually beneficial trades that no longer happen.
Price floor
A government-imposed minimum price, set above the equilibrium price to be binding. Creates a surplus (quantity supplied exceeds quantity demanded) and deadweight loss.
Price ceiling
A government-imposed maximum price, set below the equilibrium price to be binding. Creates a shortage (quantity demanded exceeds quantity supplied).
Positive analysis
Descriptive statements about "what is" in the economy. These are testable, fact-based claims (e.g. "A price floor above equilibrium creates a surplus").
Normative analysis
Prescriptive statements about "what should be" in the economy. These involve value judgements (e.g. "The government should raise the minimum wage").
Invisible hand (Adam Smith)
The idea that individuals pursuing their own self-interest in competitive markets are led, as if by an invisible hand, to promote outcomes that benefit society as a whole. Think of it as the market's built-in coordination mechanism.
Circular flow diagram
A visual model showing how money and resources flow between households and firms through two types of markets: the product market (where goods and services are sold) and the factor/resource market (where labour, land, and capital are sold).
The demand curve slopes downward: higher prices mean lower quantity demanded (law of demand).
The supply curve slopes upward: higher prices give producers more incentive to supply.
Equilibrium is the intersection. At this point, every unit that is worth producing (MC < price) is produced, and every unit that consumers value more than its price is purchased.
If the price is below equilibrium, a shortage results, because more people want the good than can get it. Competition among buyers pushes the price up.
If the price is above equilibrium, a surplus results, because sellers cannot move all their stock. Competition among sellers pushes the price down.
A change in the good's own price causes a movement along the demand or supply curve. This is not a shift.
A shift of the demand curve happens when a non-price determinant changes:
Income (normal goods: income up, demand right; inferior goods: income up, demand left)
Price of substitutes (substitute price up, demand for this good shifts right)
Price of complements (complement price up, demand for this good shifts left)
Tastes or preferences (e.g. a health scare about caffeine shifts coffee demand left)
Expectations about future prices
A shift of the supply curve happens when production conditions change:
Input costs (higher costs shift supply left)
Technology improvements (shift supply right)
Natural events (a frost destroying crops shifts supply left)
Government regulation or taxes
When both curves shift at the same time, one effect may be certain and the other ambiguous. For example, if demand shifts right (substitute price increase) and supply shifts left (crop destruction) at the same time:
The equilibrium price definitely rises (both shifts push price upward).
The equilibrium quantity is ambiguous: the demand shift increases Q, the supply shift decreases Q, and the net result depends on which shift is larger.
Elasticity tells you how sensitive consumers are to price changes at a specific point on the demand curve.
Elastic (|PED| > 1): a 1% price increase causes more than a 1% drop in quantity demanded. Revenue falls when price rises.
Inelastic (|PED| < 1): a 1% price increase causes less than a 1% drop in quantity demanded. Revenue rises when price rises.
Unit elastic (|PED| = 1): revenue is maximised at this point.
For a linear demand curve Q = a - bP, the slope dQ/dP = -b is constant, but elasticity varies along the curve because P/Q changes.
CS = area below the demand curve and above the equilibrium price. It represents the "bonus" buyers get from paying less than their maximum willingness to pay.
PS = area above the supply curve and below the equilibrium price. It represents the "bonus" sellers get from receiving more than their minimum acceptable price.
Total surplus (CS + PS) is maximised at the free-market equilibrium.
A binding price floor (set above equilibrium) creates a surplus. Quantity traded drops to the quantity demanded at the floor price. Some producer surplus may rise for those who do sell, but total welfare falls. The lost trades create deadweight loss.
A binding price ceiling (set below equilibrium) creates a shortage. Quantity traded drops to the quantity supplied at the ceiling price. Consumer surplus may rise for those who do buy, but total welfare falls.
Two markets, two sets of players:
Product market: households are buyers, firms are sellers. Households spend money on goods and services that firms produce.
Factor/resource market: households are sellers, firms are buyers. Households sell their labour, land, and capital to firms. Firms pay wages, rent, and profit in return.
Money flows in a circle: households earn income in factor markets, spend it in product markets, and firms use that revenue to pay for factors of production.
Price elasticity of demand (point elasticity)
E_d = \frac{dQ}{dP} \times \frac{P}{Q}For a linear demand Q = a - bP, the slope dQ/dP = -b. Plug in the specific P and Q at the point you are evaluating.
Worked example: Q = 300 - 100P at P = 0.50.
Q = 300 - 100(0.50) = 250
dQ/dP = -100
E_d = -100 x (0.50 / 250) = -0.2
|E_d| = 0.2 < 1, so demand is inelastic at this price.
Choke price
Set Q = 0 in the demand equation and solve for P.
Worked example: Q = 50 - 100P.
0 = 50 - 100P
100P = 50
P = 0.50
Equilibrium under perfect competition
Set P = MC (or set the supply curve equal to the demand curve) and solve for Q.
Worked example: P = 70 - 2Q, MC = 10.
10 = 70 - 2Q
2Q = 60
Q = 30, P = 10
When a frost destroys half of Colombia's coffee crop, the supply curve for coffee shifts left: prices rise at the supermarket even though nothing has changed about consumer tastes. This is the same mechanism that drives petrol price spikes after a refinery shutdown or food price increases after a drought.
Price floors are the logic behind minimum wage laws and agricultural price supports. Price ceilings are the logic behind rent control. In both cases the theoretical prediction (surplus or shortage) matches what you observe in practice.
Students often confuse a shift of the demand curve with a movement along it. A change in the good's own price is a movement along the curve. A change in income, tastes, or the price of another good is a shift.
Students often think that a price below equilibrium creates a surplus. It creates a shortage. Below equilibrium means more buyers than sellers at that price.
Students sometimes calculate elasticity using just the slope of the demand curve. The slope (dQ/dP) is only one part of the formula. You must also multiply by P/Q, which means elasticity varies along a linear demand curve even though the slope is constant.
Students often confuse positive and normative statements. A helpful test: could you verify the statement with data? If yes, it is positive. If it requires a value judgement, it is normative.
⚠️ Expect a question asking you to identify what shifts demand vs supply. Know the difference between a change in "demand" (the whole curve) and a change in "quantity demanded" (a point on it).
⚠️ Choke price calculation appears on this exam. Set Q = 0 and solve for P.
⚠️ Elasticity questions typically give you a linear demand curve and a specific price. You need to compute Q at that price, then apply the formula. Always state whether the result is elastic or inelastic.
⚠️ The simultaneous-shift question (substitute price up AND frost) is a favourite. Know that price rises for certain but quantity is ambiguous.
⚠️ Price floor and ceiling questions ask you to connect the direction of surplus or shortage to deadweight loss and changes in CS/PS.
True or false: A decrease in the price of a complement good shifts the demand curve for the related good to the right. (True.)
True or false: If the price elasticity of demand is -0.5, a price increase will reduce total revenue. (False. Demand is inelastic, so a price increase raises revenue.)
Fill in the blank: The price at which quantity demanded equals zero is called the ________. (Choke price.)
True or false: A price floor set below the equilibrium price has no effect on the market. (True. It is non-binding.)
Fill in the blank: In the circular flow diagram, households are sellers in the ________ market and buyers in the ________ market. (Factor/resource; product.)
Q: A linear demand curve is given by Q = 50 - 100P. What is the choke price?
A: Set Q = 0: 0 = 50 - 100P, so P = 0.50.
Q: If the price of tea (a substitute for coffee) doubles and a frost simultaneously destroys half the coffee crop, what happens to the equilibrium price and quantity of coffee?
A: The tea price increase shifts coffee demand right. The frost shifts coffee supply left. Both shifts push the price upward, so price rises for certain. The effect on quantity is ambiguous: the demand shift increases Q while the supply shift decreases Q. The net effect depends on the relative magnitude of the shifts.
Q: The demand for bagels is Q = 300 - 100P. Calculate the price elasticity of demand at P = 0.50. Is demand elastic or inelastic?
A: At P = 0.50, Q = 300 - 50 = 250. E_d = (-100)(0.50/250) = -0.2. Since |-0.2| < 1, demand is inelastic.
Q: A market has demand P = 70 - 2Q and all firms have MC = 10. Under perfect competition, find the equilibrium price and quantity.
A: Set P = MC: 10 = 70 - 2Q, so 2Q = 60, Q = 30, P = 10.
Q: Define consumer surplus and producer surplus. Explain why a price floor set above equilibrium creates deadweight loss.
A: CS is the difference between willingness to pay and the actual price paid. PS is the difference between the actual price received and the cost of production. A price floor above equilibrium causes quantity supplied to exceed quantity demanded, creating a surplus. The quantity traded drops to Q_d (the smaller side), so mutually beneficial trades where MB > MC no longer occur. That lost surplus is the deadweight loss.
This material connects directly to market structures (Part 2 of these notes). The perfectly competitive equilibrium (P = MC) is the benchmark against which monopoly, Cournot, and Bertrand outcomes are compared. Consumer and producer surplus reappear whenever you analyse the welfare effects of market power or government intervention.
The concept of opportunity cost connects to comparative advantage and the gains from trade (Part 3 of these notes). Understanding why trade is beneficial requires seeing that costs are not just monetary but also about what you give up.
Supply and demand, market equilibrium, equilibrium price, equilibrium quantity, shortage vs surplus, demand shift, supply shift, price elasticity of demand, elastic demand, inelastic demand, unit elastic, choke price, reservation price, consumer surplus, producer surplus, total surplus, deadweight loss, DWL, price floor, price ceiling, binding price control, non-binding price control, positive economics, normative economics, invisible hand, Adam Smith, circular flow diagram, product market, factor market, resource market, ECO3101, FIU, intermediate microeconomics