Unit 2: Microeconomics Part I - Demand, Supply & Equilibrium

Welcome to the Core of Microeconomics! This unit explores the fundamental forces that drive market economies: demand and supply. You'll learn how these forces interact to determine prices, allocate resources, and create market equilibrium. Understanding demand and supply is essential for analyzing virtually every microeconomic issue you'll encounter in IB Economics.

1. The Law of Demand

The Law of Demand: As the price of a good or service increases, the quantity demanded decreases, ceteris paribus (all other factors remaining constant). Conversely, as price decreases, quantity demanded increases.

This creates an inverse (negative) relationship between price and quantity demanded.

Mathematical Representation: \[ P \uparrow \Rightarrow Q_d \downarrow \] \[ P \downarrow \Rightarrow Q_d \uparrow \]

Why Does the Law of Demand Hold?

The law of demand is based on three key economic principles:

1. The Substitution Effect

When the price of a good increases, consumers substitute it with relatively cheaper alternatives. When price decreases, consumers buy more of that good instead of alternatives.

Example: If coffee prices rise, consumers may switch to tea. If coffee prices fall, consumers buy more coffee instead of tea.

2. The Income Effect

When the price of a good increases, consumers' real purchasing power (real income) decreases, so they buy less. When price decreases, real income effectively increases, allowing consumers to buy more.

Example: If gasoline prices double, your $100 buys less gas, reducing your real income and forcing you to purchase less.

3. The Law of Diminishing Marginal Utility

As consumers consume more units of a good, each additional unit provides less satisfaction (utility). Therefore, consumers are only willing to buy additional units at lower prices.

Example: Your first slice of pizza provides great satisfaction, but the fifth slice provides much less. You'd only buy that fifth slice if the price were lower.

The Demand Curve

Demand Curve: A graphical representation showing the relationship between price and quantity demanded. It slopes downward from left to right, reflecting the inverse relationship described by the law of demand.

📊 Demand Curve Diagram: Price (P) on vertical axis, Quantity Demanded (Qd) on horizontal axis. The curve slopes downward from top-left to bottom-right, labeled "D".

Demand vs. Quantity Demanded

Critical Distinction:

Change in Quantity Demanded: Movement ALONG the demand curve caused by a change in PRICE only
Change in Demand: SHIFT of the entire demand curve caused by changes in NON-PRICE determinants

2. Determinants of Demand (Non-Price Factors)

Several factors can shift the entire demand curve to the right (increase in demand) or left (decrease in demand):

1. Income

Normal Goods: Demand increases when income increases (positive relationship)
Example: Organic food, branded clothing, restaurant meals

Inferior Goods: Demand decreases when income increases (negative relationship)
Example: Instant noodles, public transportation (for some), second-hand goods

Normal Goods: $ \text{Income} \uparrow \Rightarrow \text{Demand} \uparrow $
Inferior Goods: $ \text{Income} \uparrow \Rightarrow \text{Demand} \downarrow $

2. Price of Related Goods

Substitute Goods: Goods that can replace each other in consumption

If the price of Good A (substitute) increases, demand for Good B increases
Examples: Butter and margarine, Coca-Cola and Pepsi, chicken and beef

$ P_{\text{substitute}} \uparrow \Rightarrow D_{\text{good}} \uparrow $

Complementary Goods: Goods consumed together

If the price of Good A (complement) increases, demand for Good B decreases
Examples: Cars and gasoline, coffee and sugar, smartphones and apps

$ P_{\text{complement}} \uparrow \Rightarrow D_{\text{good}} \downarrow $

3. Tastes and Preferences

Favorable change: Advertising campaigns, fashion trends, health awareness → Demand increases
Unfavorable change: Negative publicity, health warnings, changing trends → Demand decreases

Real-World Example: Growing health consciousness has increased demand for organic foods and gym memberships while decreasing demand for sugary drinks and fast food (in many markets).

4. Consumer Expectations

Expected future price increase: Current demand increases (buy now before price rises)
Expected future price decrease: Current demand decreases (wait for lower prices)
Expected income increase: Current demand may increase (especially for durables)

5. Number of Consumers

Population increase: Market demand increases
Demographics: Aging population increases demand for healthcare
Market expansion: More buyers enter the market → demand increases

Summary Table: Determinants of Demand

Determinant	Change	Effect on Demand	Curve Shift
Income (Normal Good)	Increases	Increases	Right
Income (Inferior Good)	Increases	Decreases	Left
Price of Substitute	Increases	Increases	Right
Price of Complement	Increases	Decreases	Left
Favorable Tastes	Change occurs	Increases	Right
Expected Future Price	Expected to rise	Increases now	Right
Number of Consumers	Increases	Increases	Right

3. The Law of Supply

The Law of Supply: As the price of a good or service increases, the quantity supplied increases, ceteris paribus. Conversely, as price decreases, quantity supplied decreases.

This creates a direct (positive) relationship between price and quantity supplied.

Mathematical Representation: \[ P \uparrow \Rightarrow Q_s \uparrow \] \[ P \downarrow \Rightarrow Q_s \downarrow \]

Why Does the Law of Supply Hold?

1. Profit Motive

Higher prices provide greater profit potential, incentivizing producers to increase production. Lower prices reduce profit margins, making production less attractive.

2. Increasing Marginal Costs

As production increases, marginal costs typically rise due to diminishing returns and capacity constraints. Higher prices are needed to cover these increasing costs and justify expanded production.

3. New Entrants

Higher prices attract new firms to enter the market, increasing total market supply. Lower prices may force some firms to exit.

The Supply Curve

Supply Curve: A graphical representation showing the relationship between price and quantity supplied. It slopes upward from left to right, reflecting the positive relationship described by the law of supply.

📊 Supply Curve Diagram: Price (P) on vertical axis, Quantity Supplied (Qs) on horizontal axis. The curve slopes upward from bottom-left to top-right, labeled "S".

Supply vs. Quantity Supplied

Critical Distinction:

Change in Quantity Supplied: Movement ALONG the supply curve caused by a change in PRICE only
Change in Supply: SHIFT of the entire supply curve caused by changes in NON-PRICE determinants

4. Determinants of Supply (Non-Price Factors)

Several factors can shift the entire supply curve to the right (increase in supply) or left (decrease in supply):

1. Costs of Production

Production costs include wages, raw materials, rent, utilities, and other inputs:

Costs increase: Supply decreases (shift left) - less profitable to produce
Costs decrease: Supply increases (shift right) - more profitable to produce

\[ \text{Production Costs} \uparrow \Rightarrow \text{Supply} \downarrow \] \[ \text{Production Costs} \downarrow \Rightarrow \text{Supply} \uparrow \]

Example: Rising oil prices increase transportation and production costs for many goods, shifting supply curves left. Alternatively, falling steel prices reduce costs for automobile manufacturers, shifting supply right.

2. Technology

Technological improvements: Increase productivity and reduce per-unit costs → Supply increases
Examples: Automation, better machinery, improved production processes

Example: 3D printing technology has increased supply in manufacturing. Agricultural innovations like drought-resistant crops increase food supply.

3. Prices of Related Goods in Production

Competitive Supply (Substitutes in Production):

Goods that can be produced using the same resources

If profit from Good A increases, producers switch resources from Good B to Good A
Supply of Good B decreases
Example: A farmer can grow wheat or corn. If wheat prices rise, the farmer allocates more land to wheat, reducing corn supply

Joint Supply (Complementary in Production):

Goods produced together from the same process

Increased production of Good A automatically increases supply of Good B
Examples: Beef and leather, crude oil and gasoline, lumber and sawdust

4. Producer Expectations

Expected future price increase: Current supply may decrease (hold inventory for higher future prices)
Expected future price decrease: Current supply increases (sell now before prices fall)
Economic optimism: Firms invest more, increasing future supply capacity

5. Number of Firms

More firms enter: Market supply increases
Firms exit: Market supply decreases
Entry/exit often depends on profitability and barriers to entry

6. Government Policies

Subsidies: Lower production costs → Supply increases
Taxes: Increase production costs → Supply decreases
Regulations: Can increase or decrease supply depending on nature
Price controls: Can affect supply decisions

7. Natural Factors and Other Shocks

Weather: Droughts, floods, perfect conditions affect agricultural supply
Natural disasters: Earthquakes, hurricanes reduce supply
Discoveries: New resource deposits increase supply

Summary Table: Determinants of Supply

Determinant	Change	Effect on Supply	Curve Shift
Production Costs	Increase	Decreases	Left
Technology	Improves	Increases	Right
Price of Substitute in Production	Increases	Decreases (for this good)	Left
Subsidies	Introduced/Increased	Increases	Right
Indirect Taxes	Introduced/Increased	Decreases	Left
Number of Firms	Increases	Increases	Right
Good Weather (Agriculture)	Occurs	Increases	Right

5. Market Equilibrium

Market Equilibrium: The point where quantity demanded equals quantity supplied. At this point, the market clears - there is no shortage or surplus, and the market is in balance.

Equilibrium Condition: \[ Q_d = Q_s \]

At equilibrium, we have:

• Equilibrium Price (P*): The price at which Qd = Qs
• Equilibrium Quantity (Q*): The quantity bought and sold at P*

📊 Equilibrium Diagram: The demand curve (D) and supply curve (S) intersect at point E (equilibrium). At this point, price is P* and quantity is Q*. The vertical axis shows Price (P), horizontal axis shows Quantity (Q).

Market Disequilibrium

When price is not at equilibrium, the market experiences either a shortage or surplus:

Surplus (Excess Supply):

Occurs when price is ABOVE equilibrium $ (P > P^*) $

Quantity supplied exceeds quantity demanded: $ Q_s > Q_d $
Unsold inventory accumulates
Market pressure pushes price DOWN toward equilibrium
As price falls: Qd increases, Qs decreases → surplus eliminated

Shortage (Excess Demand):

Occurs when price is BELOW equilibrium $ (P < P^*) $

Quantity demanded exceeds quantity supplied: $ Q_d > Q_s $
Consumers cannot buy all they want
Market pressure pushes price UP toward equilibrium
As price rises: Qd decreases, Qs increases → shortage eliminated

Changes in Equilibrium

Equilibrium price and quantity change when demand or supply shifts:

Change	Effect on P*	Effect on Q*	Example
Demand Increases (D shifts right)	Increases	Increases	Rising incomes increase demand for cars
Demand Decreases (D shifts left)	Decreases	Decreases	Health warnings reduce demand for cigarettes
Supply Increases (S shifts right)	Decreases	Increases	Technology improves, lowering costs
Supply Decreases (S shifts left)	Increases	Decreases	Bad weather reduces crop supply

Numerical Example:
Market for smartphones:

Demand: $ Q_d = 100 - 2P $
Supply: $ Q_s = 20 + 3P $

At equilibrium: $ Q_d = Q_s $
$ 100 - 2P = 20 + 3P $
$ 80 = 5P $
$ P^* = 16 $

Substitute back: $ Q^* = 100 - 2(16) = 68 $

Equilibrium: Price = $16, Quantity = 68 units

Simultaneous Shifts

When both demand and supply shift simultaneously, the effects on equilibrium depend on the relative magnitudes:

Both increase: Q* definitely increases; P* depends on which shift is larger
Both decrease: Q* definitely decreases; P* depends on which shift is larger
Demand increases, Supply decreases: P* definitely increases; Q* depends on which shift is larger
Demand decreases, Supply increases: P* definitely decreases; Q* depends on which shift is larger

6. The Price Mechanism

Price Mechanism: The process by which prices adjust through supply and demand forces to allocate resources efficiently in a market economy. It serves as an automatic system for coordinating economic decisions without central planning.

Three Functions of the Price Mechanism

1. Signaling Function

Prices communicate information to economic agents:

Rising prices signal scarcity/increasing demand → producers increase supply, consumers reduce demand
Falling prices signal abundance/decreasing demand → producers reduce supply, consumers increase demand
Prices convey information about relative scarcity and consumer preferences

Example: Rising oil prices signal scarcity, encouraging exploration, alternative energy development, and conservation.

2. Incentive Function

Prices motivate economic agents to respond:

High prices incentivize producers to increase supply and allocate more resources to that good
Low prices incentivize consumers to buy more and producers to switch resources to more profitable goods
Profit opportunities direct resources to their most valued uses

Example: High profits in smartphone industry incentivize tech companies to invest in research and production.

3. Rationing Function

Prices allocate scarce goods among competing uses:

When demand exceeds supply, rising prices ration goods to those willing and able to pay
Prevents shortages without government intervention
Resources flow to highest-value uses (those willing to pay most)

Example: During fuel shortages, higher prices ration gasoline to those who value it most, preventing queues and complete depletion.

Advantages of the Price Mechanism

Efficiency: Resources automatically flow to highest-value uses
Decentralization: No need for central planning or coordination
Flexibility: Quickly responds to changing conditions
Information: Prices aggregate millions of individual decisions
Innovation: Profit motive drives technological advancement

Limitations of the Price Mechanism

Market Failures: Externalities, public goods, information asymmetries
Inequality: Rationing by price favors the wealthy
Merit/Demerit Goods: Market may under/overprovide socially important goods
Monopoly Power: Firms may manipulate prices
Lack of Equity: Market outcomes may be socially undesirable

7. Allocative Efficiency

Allocative Efficiency: Occurs when resources are distributed in a way that maximizes social welfare. Production is allocated according to consumer preferences, and no reallocation can make anyone better off without making someone worse off (Pareto efficiency).

Condition for Allocative Efficiency

Allocative Efficiency is achieved when: \[ \text{Marginal Social Benefit (MSB)} = \text{Marginal Social Cost (MSC)} \]

In perfectly competitive markets: \[ \text{Price} = \text{Marginal Cost (MC)} \]

Or equivalently: \[ \text{Consumer Surplus} + \text{Producer Surplus is maximized} \]

Understanding Allocative Efficiency

At the market equilibrium in a competitive market:

Marginal Benefit = Price: Consumers' willingness to pay for the last unit equals the market price
Marginal Cost = Price: Producers' cost of supplying the last unit equals the market price
Therefore: MB = MC → Allocative efficiency achieved

Consumer Surplus and Producer Surplus

Consumer Surplus: The difference between what consumers are willing to pay (shown by demand curve) and what they actually pay (market price). Represents consumer benefit from trade.

Graphically: Area below demand curve and above equilibrium price \[ CS = \frac{1}{2} \times (P_{\text{max}} - P^*) \times Q^* \]

Producer Surplus: The difference between the price producers receive (market price) and the minimum price they're willing to accept (shown by supply curve). Represents producer benefit from trade.

Graphically: Area above supply curve and below equilibrium price \[ PS = \frac{1}{2} \times (P^* - P_{\text{min}}) \times Q^* \]

Total Economic Surplus = Consumer Surplus + Producer Surplus

Allocative efficiency is achieved when total economic surplus is maximized. This occurs at competitive market equilibrium where supply equals demand.

Why Market Equilibrium Achieves Allocative Efficiency

Logic of Efficiency at Equilibrium:

If Q < Q*:

For units between current Q and Q*, consumers' willingness to pay (demand) exceeds production cost (supply)
Society benefits from producing more → current situation is inefficient
Both consumers and producers gain from additional trade

If Q > Q*:

For units beyond Q*, production cost exceeds consumers' willingness to pay
Resources are wasted producing unwanted goods → inefficient
Society would be better off reducing production

At Q = Q*:

No further gains from trade possible
All mutually beneficial exchanges have occurred
Resources are allocated optimally

Allocative Inefficiency: Deadweight Loss

Deadweight Loss (DWL): The loss of economic surplus (consumer + producer surplus) that occurs when market equilibrium is not achieved. It represents the value of foregone beneficial transactions.

Deadweight loss occurs when:

Price controls: Price ceilings or floors prevent equilibrium
Taxes: Create wedge between price paid by consumers and received by producers
Subsidies: Encourage overproduction beyond efficient level
Quotas: Restrict quantity below efficient level
Monopoly: Restricts output to raise prices
Externalities: MSB ≠ MPB or MSC ≠ MPC

Numerical Example: Consumer and Producer Surplus

Market Data:
Demand: $ P = 50 - 2Q $
Supply: $ P = 10 + Q $

Step 1: Find Equilibrium
$ 50 - 2Q = 10 + Q $
$ 40 = 3Q $
$ Q^* = 13.33 $ units
$ P^* = 10 + 13.33 = 23.33 $

Step 2: Calculate Consumer Surplus
Maximum willingness to pay (when Q=0): P = 50
$ CS = \frac{1}{2} \times (50 - 23.33) \times 13.33 = 177.78 $

Step 3: Calculate Producer Surplus
Minimum acceptable price (when Q=0): P = 10
$ PS = \frac{1}{2} \times (23.33 - 10) \times 13.33 = 88.89 $

Step 4: Total Economic Surplus
$ \text{Total Surplus} = CS + PS = 177.78 + 88.89 = 266.67 $

8. Real-World Applications

Application 1: COVID-19 Pandemic Effects

Hand Sanitizer Market (Early 2020):

Demand shift: Pandemic fears → massive demand increase (D shifts right)
Supply constraints: Production couldn't immediately expand
Result: Severe shortages, price spikes, rationing
Price mechanism: High prices incentivized production expansion, new entrants
Long-run: Supply caught up, prices normalized

Application 2: Electric Vehicle Market

Factors Increasing Demand:

Environmental concerns (tastes/preferences)
Government subsidies (reduces effective price)
Rising gasoline prices (substitute)
Improved technology (expectations)

Factors Increasing Supply:

Battery technology improvements
Economies of scale
More manufacturers entering market

Result: Rapid market growth with both D and S shifting right

Application 3: Housing Market

Shortage Scenario:

Demand factors: Population growth, low interest rates, investment demand
Supply constraints: Limited land, zoning regulations, construction time
Result: D increases faster than S → rising prices, affordability crisis
Allocative efficiency: High prices signal need for more housing, but supply response is slow

9. IB Economics Exam Skills

Drawing Diagrams (Essential for IB Exams):

Always label axes: Price (P) vertical, Quantity (Q) horizontal
Label curves: D for demand, S for supply
Mark equilibrium: Point E where D and S intersect
Show changes: Use D1→D2 or S1→S2 for shifts
Indicate new equilibrium: E1→E2 with new P* and Q*
Use arrows: Show direction of shifts and price/quantity changes

Common Exam Questions:

Explain: Use chain reasoning (cause → effect → consequence)
Analyze: Use diagrams + explain mechanism
Evaluate: Consider multiple stakeholders, short-run vs. long-run, assumptions
Calculate: Practice equilibrium and surplus calculations

Sample Exam Questions

Question 1: Using a diagram, explain how a government subsidy to electric vehicle manufacturers would affect the market equilibrium. [4 marks]

Answer Structure:

Subsidy reduces production costs for manufacturers
Supply increases (S shifts right from S1 to S2)
At original price, quantity supplied > quantity demanded
Surplus puts downward pressure on price
New equilibrium: lower price (P1→P2), higher quantity (Q1→Q2)
Diagram showing S shift right, E1→E2, with P↓ and Q↑

Question 2: Explain why market equilibrium represents allocative efficiency. [4 marks]

Answer Structure:

At equilibrium, marginal social benefit (demand) = marginal social cost (supply)
All mutually beneficial trades have occurred
Consumer and producer surplus are maximized
Resources are allocated to their highest-value uses
No reallocation can improve overall welfare without making someone worse off

Question 3: Using a diagram, analyze the effects of a major drought on the wheat market. [6 marks]

Answer Structure:

Drought is a negative supply shock
Reduces crop yields → supply decreases (S shifts left)
At original price, Qd > Qs (shortage)
Shortage creates upward pressure on price
Price rises, reducing Qd and increasing Qs along new curve
New equilibrium: higher price (P↑), lower quantity (Q↓)
Consequences: Consumers pay more and buy less; producers may earn higher/lower revenue depending on elasticity; food security concerns
Diagram essential with S shift left, shortage indicated, E1→E2

10. Key Formulas Reference

Equilibrium: $ Q_d = Q_s $

Consumer Surplus: $ CS = \frac{1}{2} \times (P_{\max} - P^*) \times Q^* $

Producer Surplus: $ PS = \frac{1}{2} \times (P^* - P_{\min}) \times Q^* $

Total Economic Surplus: $ TS = CS + PS $

Allocative Efficiency: $ MSB = MSC $ or $ P = MC $

Conclusion

Demand and supply analysis forms the foundation of microeconomics. The interaction of these forces through the price mechanism determines market outcomes, allocates resources, and achieves allocative efficiency under ideal conditions. Understanding how markets work, how equilibrium is established and disrupted, and how efficiency is achieved or lost is essential for analyzing virtually every economic issue you'll encounter in IB Economics.

Master These Concepts:

The inverse relationship between price and quantity demanded (law of demand)
The positive relationship between price and quantity supplied (law of supply)
How non-price factors shift entire curves
How equilibrium is established through market forces
The three functions of the price mechanism
How competitive markets achieve allocative efficiency
How to calculate equilibrium, consumer surplus, and producer surplus

Exam Success Strategy:

Practice drawing accurate, labeled diagrams
Always distinguish between movements along curves vs. shifts of curves
Explain the mechanism: price change → shortage/surplus → adjustment → new equilibrium
Consider multiple perspectives: consumers, producers, government, society
Work through numerical examples to master calculations
Connect theory to real-world examples for deeper understanding