Demand, Supply, and Market Equilibrium: Microeconomics Study Notes

Production Possibility Curve (PPC)

PPC Shape and Efficiency

The Production Possibility Curve (PPC) illustrates the maximum possible output combinations of two goods that an economy can produce given its resources and technology. The curve typically bows outward, reflecting increasing opportunity costs as more of one good is produced.

• Allocative Efficiency: Achieved when resources are distributed to produce the mix of goods most desired by society.

• Productive Efficiency: Achieved when goods are produced at the lowest possible cost.

• Points on the PPC: Each point (A, B, C, etc.) represents a different allocation of resources between two goods (e.g., pianos and wheat).

Example: If the economy moves from point A to point B, it produces more pianos and fewer units of wheat, illustrating opportunity cost.

Circular Flow Model

Structure of the Economy

The Circular Flow Model describes the movement of resources, goods, and money between consumers and producers in the real and financial economies.

• Consumers: Provide labor and receive income.

• Producers: Use resources to produce goods and services.

• Goods Market: Where supply and demand for products interact.

• Labour Market: Where supply and demand for labor interact.

Additional info: The model helps visualize how money and goods circulate, supporting economic activity.

Demand

Definition and Law of Demand

Demand refers to the relationship between the quantity of a product consumers are willing to buy and its price, holding all other factors constant (ceteris paribus).

• Quantity Demanded: The specific amount consumers purchase at a given price.

• Law of Demand: As price increases, quantity demanded decreases, and vice versa.

Example: For a 36-inch LCD television, as the price drops from $400 to $150, the quantity demanded rises from 1 to 25 units.

Demand Curve and Shifts

The demand curve is a graphical representation showing the inverse relationship between price and quantity demanded.

• Shifts in Demand: Occur when factors other than price change, such as:

  • Average Household Income: Higher income increases demand for normal goods, decreases for inferior goods.

  • Prices of Related Goods: Substitutes (similar use) and complements (used together).

  • Tastes: Changes in consumer preferences.

  • Distribution of Income: Changes in income distribution affect demand.

  • Population: More consumers increase demand.

  • Expected Future Prices: Anticipation of higher prices increases current demand.

Supply

Definition and Law of Supply

Supply is the relationship between the quantity of a product producers are willing to sell and its price, holding all else constant.

• Law of Supply: As price increases, quantity supplied increases.

Example: For a 36-inch LCD television, as the price rises from $150 to $400, the quantity supplied increases from 5 to 28 units.

Supply Curve and Shifts

The supply curve shows the positive relationship between price and quantity supplied.

• Shifts in Supply: Occur when factors other than price change, such as:

  • Price of Inputs: Higher input costs decrease supply.

  • State of Technology: Improved technology increases supply.

  • Number of Sellers: More sellers increase supply.

  • Expected Future Price: Anticipation of higher prices may decrease current supply.

  • Price of Related Goods: Complements and substitutes in production affect supply.

Market Equilibrium

Definition and Importance

Market equilibrium occurs at the price (P*) and quantity (Q*) where quantity demanded equals quantity supplied. This is known as the market-clearing price.

• Competitive Equilibrium: All markets tend toward equilibrium, which can be competitive, Nash, or cooperative.

• Importance: Equilibrium helps predict future changes and responses to shocks.

Excess Supply and Excess Demand

When the market price is above equilibrium, there is excess supply (surplus). When below equilibrium, there is excess demand (shortage).

Shocks and Adjustments

External shocks (exogenous events) can shift demand or supply, leading to new equilibrium prices and quantities.

• Increase in Income Taxes: Demand shifts left, lowering equilibrium price and quantity.

• Increased Cost of Materials: Supply shifts left, raising price and lowering quantity.

• Price of Netflix Falls: Demand for TVs shifts right (complements), raising price and quantity.

• New Technology: Supply shifts right, lowering price and raising quantity.

• Lower Interest Rates: Demand shifts right, raising price and quantity.

Additional info: The model provides a rational explanation for any event affecting the market.

Summary Table: Demand, Supply, and Equilibrium

Concept	Definition	Key Effects
Demand	Relationship between price and quantity consumers buy	Inverse relationship; shifts due to income, tastes, etc.
Supply	Relationship between price and quantity producers sell	Positive relationship; shifts due to input costs, technology, etc.
Equilibrium	Price and quantity where demand equals supply	Market-clearing; adjusts to shocks
Excess Supply	Quantity supplied exceeds quantity demanded	Leads to price decrease
Excess Demand	Quantity demanded exceeds quantity supplied	Leads to price increase

Key Formulas

• Demand Function: $Q_d = f(P, I, P_r, T, N, E)$

• Supply Function: $Q_s = f(P, P_i, T, N_s, E)$

• Equilibrium Condition: $Q_d = Q_s$

Exam Topics Overview

• Demand, supply and equilibrium

• Shifts and shocks

• Market behaviour

• Competitive equilibrium