Supply and Demand Review
Supply and Demand Review
In the last 11 weeks, we have done a lot, so I have made this as a study guide to explain how supply and demand work, how prices are decided in markets, and why they change. These are some of the most important parts in economics and make up 15-25% of the Y12 economics exam as well as the AP exam. This unit has many new words, so use the Chinese translations to help you remember.
Review these important terms:
- Law of Demand (需求定律): When price goes up, people buy less. When price goes down, people buy more
- Ceteris Paribus (其他条件不变): “All other things stay the same”
- Quantity Demanded (需求量): How many units people buy at one price
- Demand (需求): The relationship between price and quantity (the whole curve)
- Normal Good (正常商品): When you get more money, you buy more of this (Say “When consumer incomes increase, demand increases”) ($YED>0$)
- Inferior Good (低档商品): When you get more money, you buy less of this (Say “When consumer incomes increase, demand decreases”) ($YED<0$)
- Substitute Goods (替代品): Goods that can replace each other ($XED>0$)
- Complementary Goods (互补品): Goods used together ($XED<0$)
- Law of Supply (供给定律): When price goes up, producers make more. When price goes down, producers make less
- Quantity Supplied (供给量): How many units producers sell at one price
- Supply (供给): The relationship between price and quantity for producers (the whole curve)
- Equilibrium (均衡): When buyers and sellers agree; where quantity demanded equals quantity supplied. (Say “The market, ceteris paribus, trends toward equilibrium”).
- Shortage (短缺): When quantity demanded is bigger than quantity supplied (not enough goods) ($Q_s<Q_d$)
- Surplus (过剩): When quantity supplied is bigger than quantity demanded (too many goods) ($Q_s>Q_d$)
- Consumer Surplus (消费者剩余): When you pay less than you were willing to pay (Say “The difference between what consumers were willing to pay and what they actually paid.”) [Such a happy feeling, right?]
- Producer Surplus (生产者剩余): When producers sell for more than their cost (Say “The difference between what producers were willing to accept and what they actually accepted.”) [Such a happy feeling, right?]
You must be able to draw these:
- Demand Curve: Downward sloping line showing price and quantity relationship
- Supply Curve: Upward sloping line showing producers’ behavior
- Market Equilibrium: Where demand and supply cross
- Shifted Demand: Whole curve moves left or right
- Shifted Supply: Whole curve moves left or right
- Welfare Graph: Show consumer surplus and producer surplus areas
Part 1: The Law of Demand: You buy less when the price goes up.
The Basic Rule
The Law of Demand says: When price increases, people buy less. When price decreases, people buy more. This is an inverse relationship (相反关系) (they move in opposite directions).
Example: If bubble tea costs $1, you might buy 5 cups per week. If the price jumps to $3, you might only buy 1 cup. That’s the Law of Demand.
“Ceteris Paribus”
Economists often say “ceteris paribus” or “holding all else equal.” It is is like doing a science experiment. If there are lots of things changing, you cannot know which change caused the result.
Why? If coffee price decreases AND your income increases AND tea becomes more expensive, we don’t know which change made you buy more coffee. So we analyze with “ceteris paribus.”
Income Effect and Substitution Effect
When a price changes, two things happen:
1. Substitution Effect (替代效应): The good becomes more or less expensive compared to other goods.
- Example: If Coke price increases but Pepsi stays the same, Pepsi is now relatively cheaper. You might switch to Pepsi.
2. Income Effect (收入效应): Your money doesn’t buy as much, so you feel poorer or feel richer.
- Example: If milk price increases, you can’t buy as much with your
$10. You feel poorer, so you buy less milk.
Both effects work together to make you buy less when price goes up.
Part 2: The Demand Curve
Demand Schedule and Demand Curve
A demand schedule is just a table showing price and quantity. Here’s one for lemonade.
| Price per Cup | Quantity Demanded (cups/day) |
|---|---|
$0.25 |
120 |
$0.50 |
100 |
$0.75 |
80 |
$1.00 |
60 |
$1.25 |
40 |
When we graph this, we get a downward sloping demand curve. The curve shows that as price goes down, quantity demanded goes up.
- Moving along the curve = price changes (quantity demanded changes)
- Whole curve shifts = Quantity demanded changes at EVERY PRICE because something else changes (demand changes)
What Makes the Whole Demand Curve Shift?
These are the Determinants of Demand (需求的决定因素):
1. Consumer Income (消费者收入)
- Normal goods: Income ↑ → Demand ↑ (curve shifts RIGHT)
- Inferior goods: Income ↑ → Demand ↓ (curve shifts LEFT)
Example: When you graduate and get a job, you buy more new furniture (normal good) and less used furniture (inferior good).
2. Price of Substitutes (替代品价格)
- If Pepsi price increases → Coke demand increases (shifts RIGHT)
3. Price of Complements (互补品价格)
- If hot dog buns price decreases → Hot dog demand increases (shifts RIGHT)
4. Tastes and Preferences (爱好与偏好)
- If bubble tea becomes fashionable → Demand increases
5. Future Expectations (未来预期)
- If you expect the price to increase tomorrow → Demand today increases
6. Number of Buyers (买方数量)
- More people in the city → Demand for apartments increases
Part 3: The Law of Supply
The Basic Rule for Producers
The Law of Supply says: When price increases, producers make more. When price decreases, producers make less. This is a direct relationship (正向关系).
Why? Because of increasing marginal costs (边际成本递增). Making each additional unit costs more than the last one. Producers will only make more if they can get a higher price to cover these higher costs.
Example: If lemonade price increases from $0.75 to $1.00, kids will make more lemonade because it’s worth their time.
The Supply Curve
A supply schedule shows the relationship:
| Price per Cup | Quantity Supplied (cups/day) |
|---|---|
$0.25 |
40 |
$0.50 |
60 |
$0.75 |
80 |
$1.00 |
100 |
$1.25 |
120 |
The supply curve slopes upward; price, higher quantity supplied.
Part 4: Market Equilibrium
Finding Equilibrium
Equilibrium happens where quantity demanded = quantity supplied. At this point, both buyers and sellers are happy.
From our tables above, equilibrium is at $0.75 per cup with 80 cups sold.
Shortages and Surpluses
Shortage (短缺): When quantity demanded > quantity supplied
- Happens at prices BELOW equilibrium
- Example: At $0.50, people want 100 cups but only 60 are available
- Result: Price increases until equilibrium is reached
Surplus (过剩): When quantity supplied > quantity demanded
- Happens at prices ABOVE equilibrium
- Example: At $1.00, producers make 100 cups but people only 60 are wanted
- Result: Price decreases until equilibrium is reached
Part 5: Shifting Curves
What Happens When Demand Increases?
Event: A blizzard is coming! People need to buy coats!
- Demand curve shifts RIGHT
- At old price
$20.99, there’s a shortage - New equilibrium: Price increases to
$25.
Event: War in Middle East reduces oil supply.
- Supply curve shifts LEFT
- At old price
$20, there’s a shortage - New equilibrium: Price increases, Quantity decreases
Key Rule: When supply decreases → Price ↑, Quantity ↓
Simultaneous Changes (be careful here)
When both curves shift at the same time, one result is certain, one is uncertain:
Example: Cold winter increases demand for heating AND environmental rules decrease supply.
- Price: Definitely INCREASES (both shifts push price up)
- Quantity: UNCERTAIN (demand pushes it up, supply pushes it down)
Tip: Always analyze one shift at a time, then combine the results.
Part 6: Consumer and Producer Surplus (Market Welfare)
Consumer Surplus (消费者剩余)
This is the difference between what you’re willing to pay and what you actually pay.
Example: You would pay $5 for a bubble tea, but it costs $3. Your consumer surplus is $2.
On a graph: Area under the demand curve but above the price.
Producer Surplus (生产者剩余)
This is the difference between the price producers get and their cost.
Example: It costs $1 to make a cup of lemonade, but they sell it for $2. Producer surplus is $1.
On a graph: Area above the supply curve but below the price.
Total Welfare = Consumer Surplus + Producer Surplus
At equilibrium the market gives the MAXIMUM total welfare. No other price or quantity can make society better off.
Why?
- If quantity is too low → some willing buyers and sellers can’t trade
- If quantity is too high → some trades cost more than they’re worth
Welfare is highest only at equilibrium.
Answer in your notebook using simple sentences:
- Explain the Law of Demand in your own words and give one example.
- What does “ceteris paribus” mean? Why is it important?
- Name two things that would make the demand for basketballs shift RIGHT.
- What is the difference between “quantity demanded” and “demand”?
- Draw a demand curve and label the axes correctly.
Test your supply knowledge:
- Explain the Law of Supply in your own words.
- Why do producers need higher prices to make more goods?
- Name two things that would make the supply of pizza shift LEFT.
- What happens to price when there is a shortage? Why?
- Draw a supply curve and explain why it slopes upward.
Combine your knowledge:
- If incomes increase and cars are normal goods, what happens to demand, price, and quantity?
- If a new machine makes producing phones cheaper, what happens to supply, price, and quantity?
- When both demand and supply increase, what happens to price? (Hint: it’s ambiguous!)
- How do you find consumer surplus on a graph?
- Why is market equilibrium good for society?
Summary: The Big Picture
- Demand shows what buyers want; it slopes DOWN because of income and substitution effects
- Supply shows what producers make; it slopes UP because of increasing costs
- Equilibrium is where they meet
- Shifts happen when external (Price of Good A never shifts Good A) factors change
- Welfare is maximized at equilibrium
- Price changes cause movement along curves
- External changes cause shifts of curves
- Shortages and surpluses always push the market back to equilibrium
PED: $ \frac{\% \Delta \ Q_d}{\% \Delta \ Price} $
XED: $ \frac{\% \Delta \ Q_d\ Good\ A}{\% \Delta \ Price\ Good\ B} $
PES: $ \frac{\% \Delta \ Q_s}{\% \Delta \ Price} $
YED: $ \frac{\% \Delta \ Q_d}{\% \Delta \ ‘Consumer Income’} $
Memorize these connections:
- The Law of Demand is an inverse relationship
- The Law of Supply is a direct relationship
- There are 6 determinants of demand and 6 determinants of supply
- When demand increases: Price ↑, Quantity ↑
- When supply increases: Price ↓, Quantity ↑
- Equilibrium is where $Q_d = Q_s$
- Total welfare is maximized at equilibrium
Rapid Review
- Law of Demand: Price ↑ → Quantity Demanded ↓ (inverse relationship)
- Ceteris Paribus: All other factors held constant
- Substitution Effect: Good becomes relatively more/less expensive compared to substitutes
- Income Effect: Price change affects purchasing power
- Demand Curve: Downward sloping, shows price-quantity relationship
- Determinants of Demand: Income, substitute prices, complement prices, tastes, expectations, number of buyers (You can remember some with the mnemonic HISAGE)
- Normal Good: Income ↑ → Demand ↑
- Inferior Good: Income ↑ → Demand ↓
- Law of Supply: Price ↑ → Quantity Supplied ↑ (direct relationship)
- Supply Curve: Upward sloping due to increasing marginal costs
- Determinants of Supply: Input costs, technology, taxes/subsidies, expectations, price of other outputs, number of suppliers (You can remember some with the mnemonic STORES)
- Equilibrium: Where Qd = Qs; market is stable
- Shortage: $Qd > Qs$; price will increase
- Surplus: $Qs > Qd$; price will decrease
- Consumer Surplus: Area below demand, above price; difference between willingness to pay and actual price
- Producer Surplus: Area above supply, below price; difference between price and marginal cost
- Total Welfare: Consumer Surplus + Producer Surplus; maximized at equilibrium
- Double Shifts: One result is certain, one is ambiguous