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Supply, Demand and Market Equilibrium

Subject: Economics
Topic: 2
Cambridge Code: 0455 / 2281

Demand​

Demand - Quantity consumers willing to buy at various prices

Law of Demand​

Negative relationship: Price ↑ → Quantity demanded ↓

Reasons:

  • Income effect: Higher price reduces purchasing power
  • Substitution effect: Switch to cheaper alternatives
  • Consumer surplus lost: Less benefit gained

Demand Curve​

Downward sloping from left to right

Price
  |
 10|
  |   D
  |   |\
 7.5|  | \
  |   |  \
 5|  |   \
  |   |    \
 2.5|  |     \
  |   |      \
  +---+------+---+--- Quantity
    0  10  20  30

Shifters of Demand​

Demand increases (curve shifts right):

  • Income ↑ (normal goods)
  • Price of substitutes ↑
  • Price of complements ↓
  • Tastes change favorably
  • Population ↑
  • Future price expected ↑

Demand decreases (curve shifts left):

  • Income ↓
  • Tastes change unfavorably
  • Price of substitutes ↓
  • Price of complements ↑
  • Expectations of lower prices

Types of Goods​

Normal goods: Income ↑ → Demand ↑

  • Luxury goods even more responsive

Inferior goods: Income ↑ → Demand ↓

  • Example: Budget foods

Substitutes: Can replace each other

  • Example: Butter and margarine
  • Price of one ↑ → Demand for other ↑

Complements: Used together

  • Example: Cars and petrol
  • Price of one ↑ → Demand for both ↓

Supply​

Supply - Quantity producers willing to sell at various prices

Law of Supply​

Positive relationship: Price ↑ → Quantity supplied ↑

Reasons:

  • Higher price makes production profitable
  • Existing firms expand
  • New firms enter market
  • Opportunity cost acceptable

Supply Curve​

Upward sloping from left to right

Price
  |
 10|              S
  |             /
 7.5|          /
  |         /
 5|      /
  |   /
 2.5|/
  |
  +---+------+---+--- Quantity
    0  10  20  30

Shifters of Supply​

Supply increases (curve shifts right):

  • Input costs ↓
  • Technology improves
  • Taxes ↓
  • Subsidies ↑
  • Better weather (agriculture)
  • Expectations of lower prices

Supply decreases (curve shifts left):

  • Input costs ↑
  • Technology worsens
  • Taxes ↑
  • Subsidies ↓
  • Bad weather (agriculture)
  • Expectations of higher prices

Market Equilibrium​

Equilibrium - Point where demand equals supply

Finding Equilibrium​

At equilibrium:

  • Quantity demanded = Quantity supplied
  • Price stabilizes
  • No shortage or surplus
Price
  |
 10|
  |   D    S
  | /     /
 7.5|/   /
  |X   / (Equilibrium point)
 5|  /
  | /| \
 2.5|/_|_\
  |
  +---+------+---+--- Quantity

Shortage and Surplus​

Shortage (Excess Demand):

  • Quantity demanded > Quantity supplied
  • Price below equilibrium
  • Consumers compete, price rises
  • Market moves to equilibrium

Surplus (Excess Supply):

  • Quantity supplied > Quantity demanded
  • Price above equilibrium
  • Producers compete, price falls
  • Market moves to equilibrium

Price Elasticity of Demand (PED)​

PED - Responsiveness of quantity demanded to price changes

Formula​

PED=Percentage change in quantity demandedPercentage change in pricePED = \frac{\text{Percentage change in quantity demanded}}{\text{Percentage change in price}}

Interpreting PED​

Elastic (|PED| > 1):

  • Demand very responsive to price
  • Large quantity change for small price change
  • Examples: Luxuries, substitutes available

Inelastic (|PED| < 1):

  • Demand not very responsive
  • Small quantity change for large price change
  • Examples: Necessities, few substitutes

Unit elastic (|PED| = 1):

  • Proportional change

Determinants of PED​

Demand more elastic when:

  • Close substitutes available
  • Luxury good
  • High proportion of income
  • Long time period to adjust

Demand more inelastic when:

  • No substitutes
  • Necessity
  • Small proportion of income
  • Short time period

Impact on Revenue​

Elastic demand (PED > 1):

  • Price ↑ → Revenue ↓ (better to lower price)
  • Price ↓ → Revenue ↑

Inelastic demand (PED < 1):

  • Price ↑ → Revenue ↑ (better to raise price)
  • Price ↓ → Revenue ↓

Price Elasticity of Supply (PES)​

PES - Responsiveness of quantity supplied to price changes

Formula​

PES=Percentage change in quantity suppliedPercentage change in pricePES = \frac{\text{Percentage change in quantity supplied}}{\text{Percentage change in price}}

Determinants of PES​

Supply more elastic when:

  • Easy to increase/decrease production
  • Significant spare capacity
  • Long time period
  • Mobile factors of production

Supply more inelastic when:

  • Difficult to adjust production
  • No spare capacity
  • Short time period (fixed factors)
  • Immobile resources

Key Points​

  1. Demand: Inverse relationship with price
  2. Supply: Positive relationship with price
  3. Equilibrium: Where demand = supply
  4. Shortage: Excess demand, pressure for price rise
  5. Surplus: Excess supply, pressure for price fall
  6. PED measures demand responsiveness
  7. Elastic demand > 1, Inelastic < 1
  8. Revenue depends on elasticity and price change

Practice Questions​

  1. Draw demand and supply curves
  2. Show equilibrium point
  3. Analyze shifts in demand/supply
  4. Calculate PED
  5. Predict price changes
  6. Analyze shortage/surplus
  7. Predict revenue changes

Revision Tips​

  • Know D and S law clearly
  • Practice curve shifting
  • Understand movements vs shifts
  • Calculate elasticity practice
  • Know elasticity determinants
  • Predict price and quantity changes
  • Practice real-world scenarios