Difficulty: Introductory | Prerequisites: Scarcity, Incentives, and Trade notes (Part 1). You need to be comfortable with opportunity cost and marginal thinking before this material will click.
This covers how markets work: the mechanics of supply and demand, what makes demand more or less responsive to price changes (elasticity), how different types of goods behave, and how to measure whether a market is making people better or worse off (surplus and deadweight loss). These concepts form the analytical core of introductory microeconomics. If scarcity and opportunity cost are the why of economics, supply and demand are the how.
Supply and demand curves show how price and quantity relate for buyers and sellers. Price changes cause movements along a curve; everything else (income, tastes, technology, input costs) shifts the whole curve. Elasticity measures how sensitive quantity is to those changes. Consumer and producer surplus measure the welfare gains from trade, and taxes or price controls reduce total surplus by creating deadweight loss.
Demand curve
A graph showing the quantity of a good consumers are willing and able to buy at each price, holding everything else constant. It slopes downward: higher price, lower quantity demanded.
Supply curve
A graph showing the quantity of a good producers are willing and able to sell at each price, holding everything else constant. It slopes upward: higher price, higher quantity supplied.
Movement along a curve (slide)
A change in quantity demanded or supplied caused by a change in the good's own price. Think of it as sliding up or down an existing curve.
Shift of a curve
The entire curve moves left or right because something other than price has changed (income, tastes, technology, input costs). In simple terms, at every price, the quantity is now different.
Complements
Goods used together. A price rise in one reduces demand for the other. Think of peanut butter and jam.
Substitutes
Goods used in place of each other. A price rise in one increases demand for the other. Think of Coke and Pepsi.
Normal good
A good for which demand increases as income rises. Most goods are normal goods.
Inferior good
A good for which demand decreases as income rises. Think of instant noodles: as people earn more, they switch to better alternatives.
Luxury good
A subset of normal goods where demand rises more than proportionally with income. Think of designer handbags or first-class flights.
Price elasticity of demand (PED)
A measure of how much quantity demanded responds to a change in price. In simple terms, it answers: "If I raise the price by 1%, how much does quantity drop?"
Income elasticity of demand
A measure of how much quantity demanded responds to a change in income. Positive for normal goods, negative for inferior goods.
Cross-price elasticity of demand
A measure of how quantity demanded of one good responds to a price change in another good. Positive for substitutes, negative for complements.
Consumer surplus (CS)
The difference between what consumers are willing to pay and what they do pay. Think of it as the "bonus" buyers get from a transaction.
Producer surplus (PS)
The difference between the market price and the minimum price producers would accept. Think of it as the seller's bonus.
Total surplus
The sum of consumer surplus and producer surplus. It measures the total welfare generated by a market and is maximised at the competitive equilibrium.
Deadweight loss (DWL)
The reduction in total surplus caused by a market distortion (tax, price control, monopoly). In simple terms, it is the value of trades that would have benefited both sides but no longer happen.
Tax incidence
The division of a tax's burden between buyers and sellers. It depends on the relative elasticities of supply and demand, not on who writes the cheque to the government.
The demand curve
Slopes downward (law of demand). As price rises, quantity demanded falls, all else equal.
A change in the good's own price causes a movement along the curve. Nothing else moves you along it.
The supply curve
Slopes upward (law of supply). As price rises, quantity supplied increases, all else equal.
Again, a change in the good's own price causes a movement along the curve.
Shifts vs. movements: the single most tested distinction
Movement along = price change only. The curve stays put.
Shift of the demand curve: caused by changes in income, tastes/preferences, prices of related goods (complements and substitutes), expectations, or the number of buyers.
Shift of the supply curve: caused by changes in input costs, technology, expectations, or the number of sellers.
Demand shifts outward (rightward) when consumers want more at every price. Supply shifts outward (rightward) when producers are willing to offer more at every price.
Complements and substitutes
Complements are used together. If the price of peanut butter rises, demand for jam falls (the demand curve for jam shifts left).
Substitutes are used in place of each other. If the price of Coke rises, demand for Pepsi rises (the demand curve for Pepsi shifts right).
The cross-price elasticity sign tells you which relationship applies: positive for substitutes, negative for complements.
Types of goods by income response
Normal goods: demand rises with income. Most things people buy.
Inferior goods: demand falls as income rises. Examples include instant noodles, bus travel, and own-brand products.
Luxury goods: demand rises more than proportionally with income (income elasticity > 1). Examples include designer clothing and premium holidays.
Price elasticity of demand (PED)
Elastic (PED > 1): quantity is very responsive to price. A small price increase causes a large drop in quantity demanded. Examples include luxury items and goods with many substitutes.
Inelastic (PED < 1): quantity is not very responsive to price. Even a large price increase causes only a small drop in quantity demanded. Examples include necessities, addictive goods, and goods with few substitutes.
Unit elastic (PED = 1): percentage change in quantity equals percentage change in price.
Perfectly elastic (PED = infinity): the demand curve is horizontal. Any price increase above the going rate causes quantity demanded to drop to zero.
Perfectly inelastic (PED = 0): the demand curve is vertical. Quantity demanded does not change at all regardless of price. (Rare in practice; insulin comes close for diabetics.)
What determines elasticity
Availability of substitutes (more substitutes = more elastic).
Necessity vs. luxury (necessities tend to be inelastic).
Proportion of income spent (larger share = more elastic).
Time horizon (demand tends to become more elastic over time as consumers find alternatives).
Income elasticity of demand
Positive for normal goods (demand and income move together).
Negative for inferior goods (demand falls as income rises).
Greater than 1 for luxury goods (demand rises faster than income).
Cross-price elasticity of demand
Positive: the two goods are substitutes (price of A rises, demand for B rises).
Negative: the two goods are complements (price of A rises, demand for B falls).
Near zero: the goods are unrelated.
Consumer surplus
On a graph, CS is the triangle between the demand curve and the market price, from zero quantity out to the equilibrium quantity.
It captures the total "bonus" to all buyers who would have paid more than the going price.
Producer surplus
On a graph, PS is the triangle between the market price and the supply curve, from zero quantity out to the equilibrium quantity.
It captures the total bonus to sellers who would have accepted less than the going price.
Total surplus and efficiency
Total surplus = CS + PS. It is maximised at the competitive equilibrium, where supply meets demand.
At equilibrium, every trade that benefits both sides takes place. No beneficial trades are left on the table.
How taxes affect surplus
A tax drives a wedge between the price buyers pay and the price sellers receive.
Quantity traded falls. Some trades that would have been mutually beneficial no longer happen.
CS and PS both shrink. The government collects tax revenue, but the combined loss to buyers and sellers exceeds what the government takes in. The difference is the deadweight loss.
Tax incidence and elasticity
The side of the market that is more inelastic bears more of the tax burden, regardless of whether the tax is legally imposed on buyers or sellers.
If demand is inelastic relative to supply, buyers pay most of the tax. If supply is inelastic relative to demand, sellers absorb most of it.
The legal incidence (who sends the money to the government) and the economic incidence (who actually bears the cost) are often different.
Deadweight loss
DWL is the triangle between the supply and demand curves, from the post-tax quantity to the free-market equilibrium quantity.
It represents trades that would have made both buyer and seller better off but no longer occur because of the tax.
Larger taxes create disproportionately larger deadweight losses. The DWL grows with the square of the tax rate.
Price elasticity of demand (midpoint method)
PED = \frac{(Q_2 - Q_1) / [(Q_2 + Q_1)/2]}{(P_2 - P_1) / [(P_2 + P_1)/2]}The midpoint method avoids the problem of getting different answers depending on which direction you calculate. Exams often specify this method.
Income elasticity of demand
E_I = \frac{\% \Delta Q_d}{\% \Delta \text{Income}}Cross-price elasticity of demand
E_{XY} = \frac{\% \Delta Q_d \text{ of Good X}}{\% \Delta P \text{ of Good Y}}Consumer surplus (with linear demand)
CS = \frac{1}{2} \times Q_e \times (P_{\max} - P_e)Where P_max is the y-intercept of the demand curve (the highest price any buyer would pay) and P_e is the equilibrium price.
Deadweight loss from a tax (with linear curves)
DWL = \frac{1}{2} \times \text{Tax} \times (Q_{\text{before}} - Q_{\text{after}})Governments tax cigarettes heavily in part because demand is inelastic: smokers cut back only slightly, so the tax generates substantial revenue while still discouraging some consumption. The inelastic demand also means consumers bear most of the tax burden, which is why cigarette prices have risen far more than the pre-tax cost.
Petrol taxes work similarly. Demand for petrol is inelastic in the short run (people still need to drive to work) but becomes more elastic over time as consumers buy fuel-efficient cars, move closer to work, or switch to public transport.
Students often confuse a movement along a curve with a shift of the curve. A price change moves you along. Everything else shifts the curve. This distinction appears on almost every exam.
Elasticity is frequently confused with slope. They are related but not the same. Elasticity is about percentage changes; slope is about absolute changes. A straight-line demand curve has constant slope but varying elasticity along its length.
Many students assume that whoever is legally responsible for paying a tax is the one who bears the burden. Economic incidence depends on elasticity, not on who sends the payment.
Deadweight loss is sometimes misread as the tax revenue the government collects. It is the surplus destroyed on top of what the government takes. The DWL triangle sits beside the tax-revenue rectangle, not inside it.
⚠️ "Shift vs. movement" questions are a staple. Read the question carefully: if it mentions a price change, the answer is a movement along. If it mentions income, preferences, technology, or input costs, the answer is a shift.
⚠️ Elasticity calculations using the midpoint method appear regularly. Practise until the formula is automatic.
⚠️ Expect a question on tax incidence where you must identify who bears more of the burden by comparing elasticities of supply and demand.
⚠️ Surplus and deadweight loss questions often ask you to shade or calculate areas on a supply-and-demand diagram. Know the geometry: CS is the triangle above price and below demand; PS is the triangle below price and above supply; DWL is the triangle between the curves from post-tax quantity to equilibrium quantity.
⚠️ Questions distinguishing normal, inferior, and luxury goods typically give you an income change and ask what happens to demand. The sign of income elasticity tells you.
True or false: A rise in consumer income shifts the supply curve. (False: it shifts the demand curve.)
Fill in the blank: If PED > 1, demand is described as ______. (elastic)
True or false: Cross-price elasticity is negative for substitutes. (False: it is negative for complements, positive for substitutes.)
Fill in the blank: Total surplus is maximised at the ______ point. (equilibrium)
True or false: Deadweight loss represents the tax revenue the government collects. (False: it represents surplus destroyed beyond revenue collected.)
Q: The price of coffee rises. What happens to the demand for tea, and why?
A: Demand for tea increases (the demand curve shifts right). Coffee and tea are substitutes, so a rise in the price of coffee makes tea relatively more attractive.
Q: If the government places a per-unit tax on sellers in a market where demand is perfectly inelastic, who bears the entire tax burden?
A: Buyers bear the entire burden. Perfectly inelastic demand means consumers buy the same quantity regardless of price, so sellers can pass the full tax on to them.
Q: The price of a good falls from £10 to £8, and quantity demanded rises from 100 to 130 units. Calculate the PED using the midpoint method.
A: % change in Q = (130 - 100) / [(130 + 100)/2] = 30/115 = 26.1%. % change in P = (8 - 10) / [(8 + 10)/2] = -2/9 = -22.2%. PED = 26.1 / 22.2 = 1.18 (elastic).
Q: Explain why deadweight loss increases more than proportionally as a tax rate rises.
A: DWL depends on the gap between the free-market quantity and the taxed quantity. A larger tax drives a bigger wedge, reducing quantity traded further. Because DWL is the area of a triangle (half base times height), doubling the tax roughly quadruples the DWL.
Q: A new technology lowers the cost of producing smartphones. What happens to the supply curve, equilibrium price, and equilibrium quantity?
A: The supply curve shifts rightward (more produced at every price). Equilibrium price falls and equilibrium quantity rises.
The surplus framework here leads directly into market failures (externalities, public goods) later in the course, where the question becomes: what happens to surplus when markets fail to account for all costs and benefits? Elasticity is also central to understanding how firms set prices, which connects to monopoly and market structure topics. Tax incidence analysis returns in public finance when evaluating the efficiency of different tax designs.
Supply and demand, demand curve, supply curve, shift vs movement, movement along curve, demand shifters, supply shifters, complements, substitutes, normal goods, inferior goods, luxury goods, Giffen good, Veblen good, price elasticity of demand, PED, midpoint method, elastic demand, inelastic demand, perfectly elastic, perfectly inelastic, unit elastic, income elasticity, cross-price elasticity, consumer surplus, producer surplus, total surplus, market efficiency, tax incidence, tax burden, deadweight loss, DWL, welfare economics, market distortions, price controls, ECO 101, intro to microeconomics