Microeconomics Study Guide: Demand, Supply, and Market Equilibrium

I. Introduction

Price as an Allocation Mechanism

In most economies, price serves as the primary mechanism for allocating resources. The market price is determined by two fundamental forces:

• Demand – from the consumer’s perspective

• Supply – from the producer’s perspective

II. Demand

A. Definition

• Quantity Demanded: The amount of a good that households are willing and able to purchase at a given price during a specific time period.

B. Demand Schedule

A demand schedule shows the relationship between the price of a good and the quantity demanded at each price.

Price of corn per bushel in dollars (P)	Millions of bushels of corn sold per year (Q)
7	10
6	20
5	30
4	40
3	50
2	60
1	70

C. Graph of the Demand Schedule

• The demand curve is downward sloping, reflecting the inverse relationship between price and quantity demanded.

• The height of the curve at any point shows the maximum price consumers are willing to pay for an additional unit.

Demand Curve Equation:

$P = 7 - (1/10)Q$

Ceteris Paribus: The demand curve is drawn holding all other factors constant except price.

D. Law of Demand

• As the price of a good increases, the quantity demanded falls, holding all else constant (ceteris paribus).

• Reasons: Substitution effect, income effect, and diminishing marginal benefit.

III. Supply

A. Quantity Supplied

• The amount of a commodity that a firm plans to sell at a given price and time period.

B. Supply Schedule

The supply schedule shows the relationship between price and quantity supplied.

Price of corn per bushel in dollars (P)	Millions of bushels of corn supplied per year (Q)
1	10
2	20
3	30
4	40
5	50
6	60
7	70

C. Graph of the Supply Schedule

• The supply curve is upward sloping, indicating that higher prices incentivize producers to supply more.

• Underlying reasons: increasing costs and producer motivation as prices rise.

D. Law of Supply

• As the price of a good increases, the quantity supplied increases, holding all else constant.

IV. Market Equilibrium

A. Bringing Supply and Demand Together

• The intersection of the supply and demand curves determines the equilibrium price (P*) and equilibrium quantity (Q*).

• At equilibrium, quantity supplied equals quantity demanded.

B. Algebraic Solution

• Given linear equations for supply and demand:

Supply: $P = 2 + 2Q$ Demand: $P = 32 - 3Q$

• Set supply equal to demand to solve for equilibrium:

$2 + 2Q = 32 - 3Q$ $5Q = 30$ $Q = 6$ $P = 2 + 2(6) = 14$

C. Numerical Example

P	Demand Schedule (Qd)	Supply Schedule (Qs)
0.50	10	1
0.75	8	3
1.00	6	5
1.25	3	8

Equilibrium occurs where $Q^d = Q^s$.

V. Market Disequilibrium

A. Excess Supply (Surplus)

• Occurs when $Q^s > Q^d$ at a given price.

• Leads to downward pressure on price as producers compete to sell excess goods.

B. Excess Demand (Shortage)

• Occurs when $Q^d > Q^s$ at a given price.

• Leads to upward pressure on price as buyers compete for limited goods.

C. Dynamic Laws of Supply and Demand

• If $Q^d > Q^s$, prices tend to rise.

• If $Q^s > Q^d$, prices tend to fall.

• If $Q^d = Q^s$, prices remain stable.

VI. Changes in Demand and Supply

A. Change in Quantity Demanded vs. Change in Demand

• Change in quantity demanded: Movement along the demand curve due to a price change.

• Change in demand: Shift of the entire demand curve due to a change in a non-price determinant.

• Increase in demand: Demand curve shifts right.

• Decrease in demand: Demand curve shifts left.

B. Change in Quantity Supplied vs. Change in Supply

• Change in quantity supplied: Movement along the supply curve due to a price change.

• Change in supply: Shift of the entire supply curve due to a change in a non-price determinant.

• Increase in supply: Supply curve shifts right.

• Decrease in supply: Supply curve shifts left.

VII. Determinants of Demand (Shift Factors of Demand)

• Price of related goods:

  • Substitutes: Increase in price of one increases demand for the other (e.g., Pepsi and Coke).

  • Complements: Increase in price of one decreases demand for the other (e.g., cars and gasoline).

• Average Household Income:

  • Normal goods: Demand increases as income increases.

  • Inferior goods: Demand decreases as income increases.

• Expected Future Price Levels: If prices are expected to rise, current demand increases.

• Population: Increase in population raises demand.

• Preferences (Tastes): Changes in consumer preferences shift demand.

VIII. Determinants of Supply (Shift Factors of Supply)

• Price of factors of production: Higher input prices decrease supply; lower input prices increase supply.

• Changes in Technology: Technological improvements lower production costs and increase supply.

• Prices of goods related in production:

  • Substitutes in production: If the price of one good rises, producers may switch to producing it, reducing supply of the other.

  • Complements in production: Goods produced together; an increase in the price of one increases supply of the other.

• Number of firms: More firms increase market supply.

• Expectations about future prices: Expected higher prices may decrease current supply.

• Taxes and Subsidies: Taxes decrease supply; subsidies increase supply.

• Natural disasters: Can decrease supply by disrupting production.

IX. Comparative Statics Analysis

Comparative statics examines how equilibrium price (P*) and quantity (Q*) change when one or both the supply and demand curves shift.

• If only the demand curve shifts, P* and Q* move in the direction of the demand shift.

• If only the supply curve shifts, P* and Q* move in the direction of the supply shift.

• If both curves shift, the effect on P* and Q* depends on the magnitude and direction of each shift.