Unit 2: Microeconomics Part I - Demand & Supply
Understanding Market Forces: Demand, Supply, and Equilibrium
Introduction: Markets and Prices
At the heart of microeconomics lies the study of how individual markets work. A market is any arrangement that brings buyers and sellers together to exchange goods, services, or resources. Understanding how prices are determined through the interaction of demand and supply is fundamental to economic analysis.
What This Unit Covers
- How consumer demand responds to price changes
- How producer supply responds to price changes
- What factors shift demand and supply curves
- How markets reach equilibrium
- How the price mechanism allocates resources
- What makes resource allocation efficient
1. Demand
Definition and the Law of Demand
Key Definition
Demand is the quantity of a good or service that consumers are willing and able to purchase at various prices during a given time period, ceteris paribus.
Key words:
- Willing: Consumers want to buy the product
- Able: Consumers have the purchasing power (income)
- At various prices: Demand varies with price
- During a given time period: Demand is time-specific
- Ceteris paribus: All other factors held constant
The Law of Demand
As the price of a good rises, the quantity demanded falls; as the price falls, the quantity demanded rises, ceteris paribus.
This creates an inverse (negative) relationship between price and quantity demanded.
Mathematical Expression of Demand
Demand function (linear form):
\[ Q_d = a - bP \]Where:
- • \(Q_d\) = Quantity demanded
- • \(P\) = Price
- • \(a\) = Quantity demanded when price is zero (y-intercept)
- • \(b\) = Slope coefficient (negative for downward-sloping demand)
Example: \(Q_d = 100 - 2P\)
If \(P = 10\), then \(Q_d = 100 - 2(10) = 80\) units
Why Does the Law of Demand Hold?
1. Substitution Effect:
- When price rises, consumers switch to relatively cheaper substitutes
- When price falls, the good becomes more attractive relative to substitutes
2. Income Effect:
- When price rises, real income (purchasing power) decreases, reducing quantity demanded
- When price falls, real income increases, allowing more purchases
3. Law of Diminishing Marginal Utility:
- Each additional unit consumed provides less satisfaction
- Consumers only buy more if price decreases to match lower marginal utility
📉 DEMAND CURVE
Vertical Axis: Price (P)
Horizontal Axis: Quantity Demanded (Q)
Curve: Downward-sloping from left to right
Label: D
Individual vs. Market Demand
Market Demand
Market demand is the horizontal summation of all individual demand curves:
\[ Q_{market} = Q_{d1} + Q_{d2} + Q_{d3} + ... + Q_{dn} \]Example:
Consumer A: \(Q_{d1} = 50 - P\)
Consumer B: \(Q_{d2} = 40 - P\)
Market Demand: \(Q_{market} = 90 - 2P\)
Determinants of Demand (Non-Price Factors)
These factors cause the entire demand curve to shift left or right:
1. Income (Y)
Normal Goods: Demand increases when income rises (positive relationship)
- Examples: Restaurant meals, vacations, new cars
- Higher income → Rightward shift in demand
Inferior Goods: Demand decreases when income rises (negative relationship)
- Examples: Instant noodles, public transportation (for some), second-hand goods
- Higher income → Leftward shift in demand
2. Prices of Related Goods
Substitutes: Goods that can replace each other
- Examples: Tea and coffee, butter and margarine, Coca-Cola and Pepsi
- If price of tea rises → Demand for coffee increases (rightward shift)
- If price of tea falls → Demand for coffee decreases (leftward shift)
Complements: Goods consumed together
- Examples: Cars and gasoline, printers and ink cartridges, smartphones and apps
- If price of cars rises → Demand for gasoline decreases (leftward shift)
- If price of cars falls → Demand for gasoline increases (rightward shift)
3. Tastes and Preferences (T)
- Changes in consumer preferences affect demand
- Influenced by advertising, fashion, health trends, social norms
- Example: Growing health consciousness increases demand for organic food
- Example: Celebrity endorsements increase demand for specific brands
4. Expectations (E)
- Price expectations: If consumers expect prices to rise, current demand increases
- Income expectations: If expecting higher future income, current demand may increase
- Example: Rumors of fuel shortages increase current demand for gasoline
5. Number of Buyers (N)
- Population increase → Market demand increases (rightward shift)
- More consumers enter the market → Higher total demand
- Example: Immigration increases demand for housing
Demand Function with All Determinants
\[ Q_d = f(P, Y, P_s, P_c, T, E, N) \]Where:
- • \(P\) = Price of the good
- • \(Y\) = Income
- • \(P_s\) = Price of substitutes
- • \(P_c\) = Price of complements
- • \(T\) = Tastes and preferences
- • \(E\) = Expectations
- • \(N\) = Number of buyers
Movement Along vs. Shift of Demand Curve
Critical Distinction for IB Exams
Movement Along the Demand Curve:
- Caused by a change in the product's own price
- Called "change in quantity demanded"
- Movement up/down the same curve
Shift of the Demand Curve:
- Caused by changes in non-price determinants
- Called "change in demand"
- Entire curve shifts left or right
- Rightward shift = Increase in demand
- Leftward shift = Decrease in demand
Real-World Example: Smartphone Market
Movement Along: Apple reduces iPhone price from $1000 to $800 → Quantity demanded increases from 10 million to 15 million units (movement down the demand curve)
Shift Right: Launch of new popular apps increases consumer preference for smartphones → At every price, more smartphones are demanded (entire curve shifts right)
Shift Left: Economic recession reduces consumer income → At every price, fewer smartphones are demanded (entire curve shifts left)
2. Supply
Definition and the Law of Supply
Key Definition
Supply is the quantity of a good or service that producers are willing and able to produce and sell at various prices during a given time period, ceteris paribus.
Key words:
- Willing: Producers want to sell the product
- Able: Producers have the resources and capacity
- At various prices: Supply varies with price
- During a given time period: Supply is time-specific
- Ceteris paribus: All other factors held constant
The Law of Supply
As the price of a good rises, the quantity supplied rises; as the price falls, the quantity supplied falls, ceteris paribus.
This creates a direct (positive) relationship between price and quantity supplied.
Mathematical Expression of Supply
Supply function (linear form):
\[ Q_s = c + dP \]Where:
- • \(Q_s\) = Quantity supplied
- • \(P\) = Price
- • \(c\) = Constant term (can be negative)
- • \(d\) = Slope coefficient (positive for upward-sloping supply)
Example: \(Q_s = -20 + 3P\)
If \(P = 10\), then \(Q_s = -20 + 3(10) = 10\) units
If \(P = 20\), then \(Q_s = -20 + 3(20) = 40\) units
Why Does the Law of Supply Hold?
- Profit Motive: Higher prices mean higher potential profits, incentivizing increased production
- Law of Diminishing Returns: As output increases, marginal cost rises, requiring higher prices to justify production
- New Entrants: Higher prices attract new firms into the market
- Opportunity Cost: Higher prices make it worthwhile to shift resources from alternative uses
📈 SUPPLY CURVE
Vertical Axis: Price (P)
Horizontal Axis: Quantity Supplied (Q)
Curve: Upward-sloping from left to right
Label: S
Individual vs. Market Supply
Market Supply
Market supply is the horizontal summation of all individual supply curves:
\[ Q_{market} = Q_{s1} + Q_{s2} + Q_{s3} + ... + Q_{sn} \]Example:
Firm A: \(Q_{s1} = -10 + 2P\)
Firm B: \(Q_{s2} = -5 + P\)
Market Supply: \(Q_{market} = -15 + 3P\)
Determinants of Supply (Non-Price Factors)
These factors cause the entire supply curve to shift left or right:
1. Costs of Factors of Production (C)
- Labor costs (wages): Higher wages → Higher production costs → Supply decreases (leftward shift)
- Raw material costs: Higher input prices → Supply decreases
- Energy costs: Higher electricity/fuel prices → Supply decreases
- Rent: Higher property costs → Supply decreases
Example: Steel price increase reduces supply of cars (leftward shift)
2. Technology (T)
- Improved technology → Lower production costs → Supply increases (rightward shift)
- Automation and mechanization increase efficiency
- Example: Agricultural machinery increases crop supply
- Example: 3D printing technology reduces manufacturing costs
3. Prices of Related Goods in Production
Competitive Supply (Alternative Products):
- Goods produced using the same resources
- Example: Farmer can grow wheat or corn on the same land
- If price of corn rises → Farmers switch to corn → Supply of wheat decreases
Joint Supply (By-products):
- Goods produced together from the same production process
- Example: Beef and leather; petroleum and gasoline
- If demand for beef rises → More cattle slaughtered → Supply of leather increases
4. Producer Expectations (E)
- If producers expect higher future prices → May withhold current supply (leftward shift)
- If producers expect lower future prices → May increase current supply (rightward shift)
- Example: Oil companies expecting price increase may reduce current supply
5. Government Intervention (G)
- Subsidies: Government payments to producers → Lower production costs → Supply increases (rightward shift)
- Indirect Taxes: Taxes on production → Higher costs → Supply decreases (leftward shift)
- Regulations: Safety/environmental regulations → Higher compliance costs → Supply decreases
- Example: Agricultural subsidies increase food supply
6. Number of Firms (N)
- More firms enter the market → Market supply increases (rightward shift)
- Firms exit the market → Market supply decreases (leftward shift)
- Example: New smartphone manufacturers increase market supply
7. Natural Factors (Weather, Disasters)
- Favorable weather → Increased agricultural supply (rightward shift)
- Drought, floods, natural disasters → Decreased supply (leftward shift)
- Example: Good monsoon season increases rice supply in Asia
Supply Function with All Determinants
\[ Q_s = f(P, C, T, P_r, E, G, N, W) \]Where:
- • \(P\) = Price of the good
- • \(C\) = Costs of production
- • \(T\) = Technology
- • \(P_r\) = Prices of related goods in production
- • \(E\) = Expectations
- • \(G\) = Government policies
- • \(N\) = Number of firms
- • \(W\) = Weather/natural factors
Movement Along vs. Shift of Supply Curve
Critical Distinction for IB Exams
Movement Along the Supply Curve:
- Caused by a change in the product's own price
- Called "change in quantity supplied"
- Movement up/down the same curve
Shift of the Supply Curve:
- Caused by changes in non-price determinants
- Called "change in supply"
- Entire curve shifts left or right
- Rightward shift = Increase in supply
- Leftward shift = Decrease in supply
Real-World Example: Coffee Market
Movement Along: Coffee price increases from $5 to $8 per kg → Coffee farmers supply more (movement up the supply curve)
Shift Right: New irrigation technology reduces farming costs → At every price, farmers supply more coffee (entire curve shifts right)
Shift Left: Drought in Brazil (major producer) → At every price, less coffee is available (entire curve shifts left)
3. Market Equilibrium
Definition of Market Equilibrium
Market equilibrium occurs when quantity demanded equals quantity supplied at a particular price. At this point, there is no tendency for the price to change, and the market clears.
Equilibrium Price (P*): The price at which quantity demanded equals quantity supplied
Equilibrium Quantity (Q*): The quantity bought and sold at the equilibrium price
Finding Market Equilibrium Mathematically
Set quantity demanded equal to quantity supplied:
\[ Q_d = Q_s \]Example:
Demand: \(Q_d = 100 - 2P\)
Supply: \(Q_s = -20 + 3P\)
At equilibrium:
\[ 100 - 2P = -20 + 3P \] \[ 120 = 5P \] \[ P^* = 24 \]Substitute back to find quantity:
\[ Q^* = 100 - 2(24) = 52 \text{ units} \]Equilibrium: Price = $24, Quantity = 52 units
⚖️ MARKET EQUILIBRIUM
Vertical Axis: Price (P)
Horizontal Axis: Quantity (Q)
Downward-sloping Demand curve (D)
Upward-sloping Supply curve (S)
Intersection point: E (Equilibrium)
At E: P* (equilibrium price) and Q* (equilibrium quantity)
Disequilibrium: Shortage and Surplus
Shortage (Excess Demand)
Occurs when: Price is below equilibrium (\(P < P^*\))
Result: \(Q_d > Q_s\)
Market Response:
- Consumers compete for limited goods
- Shortages put upward pressure on price
- Price rises until equilibrium is reached
- As price rises: quantity demanded decreases, quantity supplied increases
Example: Concert tickets priced too low → Long queues and scalping
Surplus (Excess Supply)
Occurs when: Price is above equilibrium (\(P > P^*\))
Result: \(Q_s > Q_d\)
Market Response:
- Producers have unsold inventory
- Surplus puts downward pressure on price
- Price falls until equilibrium is reached
- As price falls: quantity demanded increases, quantity supplied decreases
Example: Agricultural products priced too high → Unsold produce
Calculating Shortage or Surplus
Shortage:
\[ \text{Shortage} = Q_d - Q_s \text{ (when } Q_d > Q_s\text{)} \]Surplus:
\[ \text{Surplus} = Q_s - Q_d \text{ (when } Q_s > Q_d\text{)} \]Example:
If \(Q_d = 100 - 2P\) and \(Q_s = -20 + 3P\), and market price \(P = 20\):
\(Q_d = 100 - 2(20) = 60\)
\(Q_s = -20 + 3(20) = 40\)
Shortage = 60 - 40 = 20 units
Changes in Market Equilibrium
When demand or supply shifts, a new equilibrium is established:
| Change | Curve Shift | Effect on Price | Effect on Quantity |
|---|---|---|---|
| Increase in Demand | D shifts right | ↑ Increase | ↑ Increase |
| Decrease in Demand | D shifts left | ↓ Decrease | ↓ Decrease |
| Increase in Supply | S shifts right | ↓ Decrease | ↑ Increase |
| Decrease in Supply | S shifts left | ↑ Increase | ↓ Decrease |
Multiple Shifts: Complex Scenarios
Scenario 1: Both Demand and Supply Increase
- Quantity definitely increases
- Price effect is ambiguous (depends on relative magnitudes of shifts)
Scenario 2: Demand Increases, Supply Decreases
- Price definitely increases
- Quantity effect is ambiguous
Example: Oil market during geopolitical crisis
- Demand increases (panic buying, stockpiling)
- Supply decreases (production disruptions)
- Result: Price rises sharply, quantity change uncertain
4. The Price Mechanism
What is the Price Mechanism?
The price mechanism (also called the market mechanism) is the system by which prices are determined through the free interaction of demand and supply without government intervention. It is often called the "invisible hand" of the market (Adam Smith's concept).
Three Functions of the Price Mechanism
1. Signaling Function
Prices provide information to buyers and sellers about market conditions:
- High prices signal: Scarcity, strong demand, or low supply
- Low prices signal: Abundance, weak demand, or high supply
- Rising prices signal: Increasing scarcity or demand
- Falling prices signal: Decreasing scarcity or demand
Example: Rising oil prices signal scarcity, prompting consumers to conserve and producers to increase exploration
2. Incentive Function
Prices motivate economic agents to change their behavior:
- For Producers: Higher prices incentivize increased production and entry into the market
- For Consumers: Lower prices incentivize increased consumption
- Resource Allocation: Producers move resources toward more profitable activities
Example: High smartphone prices encourage firms to enter the mobile phone market
3. Rationing Function
Prices allocate scarce resources among competing uses:
- Only those willing and able to pay the market price obtain the good
- Prevents shortages by ensuring quantity demanded equals quantity supplied
- Acts as a filtering mechanism when supply is limited
Example: Concert tickets are rationed to those willing to pay the price, preventing everyone from attending sold-out shows
Price Mechanism in Action: Real Estate Market
Scenario: Tech companies open offices in a small city
Signaling: Increased demand signals housing scarcity → Prices rise
Incentive: Higher prices motivate:
- Developers to build new housing (supply increases)
- Some residents to sell/rent properties
- Some potential buyers to look elsewhere (demand adjusts)
Rationing: Higher prices ensure housing goes to those who value it most (highest willingness to pay)
Result: Market moves toward new equilibrium with higher prices and quantities
Advantages of the Price Mechanism
- Efficient Resource Allocation: Resources flow to where they are most valued
- No Central Planning: Decentralized decision-making by millions of individuals
- Flexibility: Quickly adapts to changing conditions
- Consumer Sovereignty: Consumer preferences drive production decisions
- Innovation Incentive: Profit motive encourages product development
Limitations of the Price Mechanism
- Inequality: Only those with purchasing power can access goods (may not be equitable)
- Market Failures: Doesn't account for externalities, public goods, or merit goods
- Undesirable Goods: May produce harmful products (cigarettes, weapons)
- Short-term Focus: May neglect long-term sustainability
- Information Problems: Assumes perfect information, which rarely exists
5. Allocative Efficiency
Definition
Allocative efficiency occurs when resources are allocated in a way that maximizes total surplus (consumer surplus + producer surplus) and society's welfare. It is achieved when the price consumers are willing to pay equals the marginal cost of production.
Condition for allocative efficiency:
\[ P = MC \]Where P = Price and MC = Marginal Cost
Consumer Surplus
Definition and Calculation
Consumer surplus is the difference between what consumers are willing to pay for a good and what they actually pay (market price).
It represents the benefit consumers receive from purchasing at market price.
Consumer Surplus Formula
For a linear demand curve:
\[ \text{Consumer Surplus} = \frac{1}{2} \times Q^* \times (P_{max} - P^*) \]Where:
- • \(Q^*\) = Equilibrium quantity
- • \(P_{max}\) = Maximum price consumers would pay (y-intercept of demand)
- • \(P^*\) = Equilibrium price
Graphically: Triangle area above equilibrium price, below demand curve
Example:
Demand: \(Q_d = 100 - 2P\), so \(P_{max} = 50\) when \(Q = 0\)
If \(P^* = 24\) and \(Q^* = 52\):
\[ CS = \frac{1}{2} \times 52 \times (50 - 24) = \frac{1}{2} \times 52 \times 26 = 676 \]Producer Surplus
Definition and Calculation
Producer surplus is the difference between the market price producers receive and the minimum price they would be willing to accept (marginal cost).
It represents the benefit producers receive from selling at market price.
Producer Surplus Formula
For a linear supply curve:
\[ \text{Producer Surplus} = \frac{1}{2} \times Q^* \times (P^* - P_{min}) \]Where:
- • \(Q^*\) = Equilibrium quantity
- • \(P^*\) = Equilibrium price
- • \(P_{min}\) = Minimum price at which producers would supply (y-intercept of supply)
Graphically: Triangle area below equilibrium price, above supply curve
Example:
Supply: \(Q_s = -20 + 3P\), so \(P_{min} = 6.67\) when \(Q = 0\)
If \(P^* = 24\) and \(Q^* = 52\):
\[ PS = \frac{1}{2} \times 52 \times (24 - 6.67) = \frac{1}{2} \times 52 \times 17.33 = 450.6 \]Total Social Surplus
Social Welfare
\[ \text{Total Social Surplus} = \text{Consumer Surplus} + \text{Producer Surplus} \]At market equilibrium: Total social surplus is maximized
This is why competitive market equilibrium is allocatively efficient.
Allocative Efficiency at Market Equilibrium
Why Market Equilibrium is Allocatively Efficient:
- At equilibrium, the marginal benefit to consumers (reflected by demand) equals the marginal cost to producers (reflected by supply)
- No further gains from trade are possible
- Total surplus is maximized
- Resources cannot be reallocated to make someone better off without making someone else worse off (Pareto efficiency)
Allocative Inefficiency
Occurs when:
- Underproduction: Quantity < Equilibrium → Deadweight loss (potential surplus not realized)
- Overproduction: Quantity > Equilibrium → Deadweight loss (marginal cost exceeds marginal benefit)
- Price Controls: Government-set prices create shortages or surpluses
- Market Failures: Externalities, public goods, information asymmetries
Real-World Application: Water Market
Scenario: Free market for bottled water
Equilibrium: Price = $1 per bottle, Quantity = 1000 bottles
Consumer Surplus: People willing to pay $3 but only pay $1 → Gain $2 per bottle
Producer Surplus: Producers willing to sell at $0.50 but receive $1 → Gain $0.50 per bottle
Allocative Efficiency: Total surplus maximized at this equilibrium
What if government sets price at $0.75?
- Quantity demanded increases (more people want water)
- Quantity supplied decreases (less profitable)
- Shortage develops
- Deadweight loss occurs (some mutually beneficial trades don't happen)
- Allocatively inefficient
Putting It All Together: Market Analysis Framework
Step-by-Step Market Analysis
1. Identify Initial Equilibrium
- Draw supply and demand curves
- Mark equilibrium price (\(P^*\)) and quantity (\(Q^*\))
2. Identify the Change
- Determine what factor has changed
- Classify as demand or supply determinant
3. Determine Direction of Shift
- Rightward shift = Increase
- Leftward shift = Decrease
4. Find New Equilibrium
- Mark new intersection point
- Identify new \(P^*\) and \(Q^*\)
5. Analyze Changes
- Compare old vs. new price
- Compare old vs. new quantity
- Discuss impact on consumer/producer surplus
Complete Market Analysis: Electric Vehicles (EVs)
Initial Situation: EV market in equilibrium at Price = $40,000, Quantity = 500,000 units
Change 1: Government introduces EV purchase subsidy
- Effect: Demand increases (rightward shift)
- Reason: Lower effective price for consumers
- New Equilibrium: Higher price, higher quantity
Change 2: Battery technology improves (lower production costs)
- Effect: Supply increases (rightward shift)
- Reason: Technology reduces costs
- New Equilibrium: Lower price, higher quantity
Combined Effect: Both changes occur simultaneously
- Quantity definitely increases (both shifts increase Q)
- Price effect uncertain (demand pushes up, supply pushes down)
- Depends on relative magnitude of shifts
Key Formulas Summary
Essential Equations for IB Economics
Demand Function:
\[ Q_d = a - bP \]Supply Function:
\[ Q_s = c + dP \]Equilibrium Condition:
\[ Q_d = Q_s \]Shortage:
\[ \text{Shortage} = Q_d - Q_s \]Surplus:
\[ \text{Surplus} = Q_s - Q_d \]Consumer Surplus:
\[ CS = \frac{1}{2} \times Q^* \times (P_{max} - P^*) \]Producer Surplus:
\[ PS = \frac{1}{2} \times Q^* \times (P^* - P_{min}) \]Total Social Surplus:
\[ TSS = CS + PS \]Allocative Efficiency:
\[ P = MC \]Common Mistakes to Avoid
- Confusing movement along vs. shift: Price changes cause movements; other factors cause shifts
- Incorrect shift direction: Remember which determinants increase/decrease demand or supply
- Wrong terminology: Say "change in quantity demanded" for movements, "change in demand" for shifts
- Forgetting ceteris paribus: Always assume other factors constant unless specified
- Mixing up surplus types: Consumer surplus is for buyers, producer surplus is for sellers
- Ignoring units: Always include units in calculations (dollars, units, etc.)
IB Exam Tips
- Diagrams are crucial: Always draw and label supply-demand diagrams accurately
- Label everything: Axes, curves, equilibrium points, shifts
- Use arrows: Show direction of shifts clearly
- Explain in words: Don't rely only on diagrams; explain the economic reasoning
- Define key terms: Start answers by defining demand, supply, equilibrium, etc.
- Show calculations: For numerical questions, show all steps
- Real-world examples: Use current events to illustrate concepts
- Evaluation: Discuss limitations, assumptions, and alternative perspectives
✓ Unit 2 Study Checkpoint
You should now understand the laws of demand and supply, the determinants that shift these curves, how markets reach equilibrium, how the price mechanism allocates resources, and what makes resource allocation allocatively efficient. These concepts form the foundation for all further microeconomic analysis in IB Economics SL, including market failures, elasticity, and government intervention.