Supply and demand

THE TASK VERB SETS THE RESPONSE JOB

The official verbs describe what a complete response must do.

On this unit the verb usually names an area or a direction. “Shade the deadweight loss” is a draw task; “explain what happens to consumer surplus” wants the direction and the reason; “calculate the tax revenue” wants a rectangle’s arithmetic on the page.

DEMAND: A ROW OF BUYERS, AND WHAT MOVES THEM

What the model assumes first. A market needs a well-defined system of property rights to function well — a seller can offer only what it owns and can transfer. Inside it, economic agents respond to incentives, and the price is the incentive this unit studies; but buyers also act under constraints — income, time, and the legal and regulatory frameworks around them — and the demand curve is what those incentives and constraints produce. The exam’s definitions of consumer decision making start there.

The law of demand. Other things equal, a higher price of a good lowers the quantity of it demanded; a lower price raises it. This is a movement along the demand curve, and the quantity that changes is called quantity demanded.

Why the curve slopes down — three reasons the exam accepts. The substitution effect: when the price rises, other goods look cheaper by comparison and buyers move toward them. The income effect: at a higher price a given income buys less, so buyers can afford less of everything, this good included. And diminishing marginal utility from Unit 1: each extra unit is worth less to a buyer, so a buyer takes an extra unit only at a lower price. Any one of them answers “explain why the demand curve is downward sloping”; the first two are the Course and Exam Description’s own words.

The demand curve is a marginal benefit curve. Read it vertically: at each quantity, the height of the curve is the most the marginal buyer would pay for that unit. That reading is what makes consumer surplus an area, and it is why the demand curve reappears in every later unit under the name $\mathrm{MB}$.

Market demand is a horizontal sum. At each price, add every buyer’s quantity. The market curve is flatter than any one buyer’s, and it bends where a buyer drops out or enters. Problem 1 builds one.

What shifts demand. Anything other than the good’s own price that changes how much buyers want at every price. Demand rises (the curve moves right) when buyers want more at each price; it falls (left) when they want less.

The one thing that never shifts demand: the good’s own price. A price change moves the buyer along the curve that is already there. Writing “the price fell, so demand rose” describes a shift that did not happen; the sentence that scores is “the price fell, so quantity demanded rose.”

SUPPLY: A ROW OF SELLERS, AND WHAT MOVES THEM

The law of supply. Other things equal, a higher price raises the quantity supplied; a lower price lowers it — a movement along an upward-sloping supply curve. Read vertically, the supply curve is a marginal cost curve: at each quantity its height is the least the marginal seller would accept for that unit, because that is what the unit costs to make. Market supply is the horizontal sum of the sellers’ curves.

What shifts supply. Anything other than the good’s own price that changes what sellers will offer at every price. Supply rises (right) when producing is cheaper or easier; it falls (left) when producing is costlier.

Reading a shift as a vertical distance. A supply curve can move “left” or “up”; for a tax they are the same move. Up by $6 means: at every quantity, sellers now need $6 more to offer that unit. Thinking of supply shifts vertically is what makes taxes and subsidies easy to draw, so practice reading both ways.

PRICE ELASTICITY OF DEMAND: PERCENTAGES, OR IT IS NOT AN ELASTICITY

The definition. Price elasticity of demand measures how much quantity demanded responds to a price change, as a ratio of percentage changes:

The sign is always negative for a normal demand curve; report the magnitude and say which range it falls in.

The wrong number, named. $\mathrm{\Delta }Q∕\mathrm{\Delta }P$ — the change in quantity divided by the change in price — is the slope’s reciprocal. It has units (units per dollar), it is the same everywhere on a straight line, and it depends on whether you measured in thousands or in units. None of that can be true of an elasticity, which is a pure number that varies along the line. The College Board names this exact error as the one to expect. Write both percentages out before dividing and it cannot happen.

Which base? Unless the prompt says otherwise, use the percentage change from the initial values, as above. The midpoint method uses the average of the two values as the base for each percentage, ${\displaystyle \frac{Q_2-Q_1}{(Q_1+Q_2)∕2}}$ over ${\displaystyle \frac{P_2-P_1}{(P_1+P_2)∕2}}$, and gives the same number whichever direction the price moved. Use it when the prompt asks for it, or names an arc elasticity; otherwise use the initial values and say so.

Slope is not elasticity. On a straight-line demand curve the slope never changes and the elasticity changes at every point: elastic in the upper half, unit elastic at the midpoint, inelastic in the lower half. Total revenue, $P\times Q$, is a hill whose peak sits at that midpoint.

The total revenue test follows from the hill. If demand is elastic, price and total revenue move in opposite directions: a price cut raises revenue. If demand is inelastic, they move together: a price cut lowers revenue, and a price rise raises it. For a finite change measured with midpoint elasticity, unit elasticity means unchanged revenue. With two exact price–quantity pairs, checking $P\times Q$ directly is decisive. An initial-value percentage calculation can classify a large interval differently: from $(P,Q)=\left(\mathrm{12,40}\right)$ to $\left(\mathrm{8,60}\right)$ its magnitude is 1.5, yet revenue is $480 at both ends. This is how the exam usually asks about elasticity without saying the word — “the store cut its price and its revenue rose; what does that tell you about demand?”

What makes demand elastic. The availability of close substitutes is the one the Course and Exam Description names; a good with many substitutes is elastic because buyers can leave. Also: a larger share of the buyer’s budget (more elastic), a luxury rather than a necessity (more elastic), and more time to adjust (more elastic in the long run).

PRICE ELASTICITY OF SUPPLY, AND THE OTHER ELASTICITIES

Supply. The same ratio, on the sellers’ side:

positive, with the same benchmarks: elastic above 1, inelastic below, unit at 1, perfectly elastic horizontal, perfectly inelastic vertical. What makes supply elastic is how easily sellers can change output: spare capacity, movable inputs, and above all time — supply is nearly vertical in the moment (the concert is tonight; the seats are the seats), steep in the short run, and flat in the long run when new sellers can enter. The Course and Exam Description’s named factor is “the price of alternative inputs”: if the seller can switch to a cheaper input as it expands, supply is more elastic.

Income elasticity of demand measures how quantity demanded responds to a change in buyers’ income:

Cross-price elasticity of demand measures how the quantity of one good responds to the price of another:

For these two, the sign is the answer. Price elasticity of demand is reported as a magnitude because its sign is always the same; income and cross-price elasticities are reported with their sign because the sign is the classification the question is after. Compute the number, keep the sign, then name the good. Problem 4 does all three.

MARKET EQUILIBRIUM, AND THE TWO AREAS BESIDE IT

Equilibrium is the price at which quantity demanded equals quantity supplied — the market clears: every buyer willing to pay the price finds a seller, every seller willing to accept it finds a buyer, and there is neither a shortage nor a surplus. In a competitive market with no failures, that price and quantity are efficient: no other quantity creates more total surplus.

Finding it. From two schedules, scan for the price where the quantities match. From two equations, set them equal and solve: with demand $P=60-2Q$ and supply $P=12+Q$, $60-2Q=12+Q$ gives $Q=16$ and $P=28$. Check by putting $Q=16$ into both equations; if they disagree, the algebra slipped.

Consumer surplus is what buyers gained: for every unit, the most its buyer would have paid minus what was actually paid, summed. On the graph that is the area under the demand curve, above the price, out to the quantity traded. Producer surplus is the mirror: what sellers received minus the least they would have accepted — above the supply curve, below the price, out to the quantity traded. Their sum is total economic surplus, the whole gain the market creates.

The triangle’s dimensions, said precisely. Base is the quantity traded, along the axis. Height is a vertical distance on the price axis: from the price up to the demand intercept for CS, from the price down to the supply intercept for PS. Both areas are in dollars (quantity $\times$ dollars per unit), and if the quantity axis is in thousands, so is the area. With schedules rather than lines, sum the per-unit gaps instead; Problem 5 does both.

What the price is for. The equilibrium price is information. It tells every buyer and seller what a unit is worth at the margin, and resources move toward the uses where that signal says they are valued most: a price that rises after a demand shift is not only an outcome, it is the instruction that pulls more inputs into making the good. That is why the Course and Exam Description says the equilibrium price “provides information to economic decision-makers to guide resource allocation.”

Why equilibrium is efficient. Every unit up to 16 has a buyer who values it above the seller’s cost — the demand curve is above the supply curve — so trading it adds to total surplus. The 17th unit would cost more to make than any remaining buyer would pay, so trading it would subtract. Total surplus therefore peaks exactly where the curves cross, and any policy that moves the quantity away from it, in either direction, throws some of that surplus away. That thrown-away amount has a name in the next cards: deadweight loss.

DISEQUILIBRIUM, AND CHANGES IN EQUILIBRIUM

A price that is not the equilibrium price. Above it, sellers offer more than buyers take: a surplus of $Q_s-Q_d$, and unsold goods push the price down. Below it, buyers want more than sellers offer: a shortage of $Q_d-Q_s$, and unmet buyers bid the price up. Market forces drive the price back to equilibrium unless something holds it away — which is what a price control does. Read $Q_d$ and $Q_s$ off the two curves at the stated price; the difference is the surplus or shortage, and the smaller of the two is what actually trades.

One curve shifts. Four cases, and each has a determinate answer for both price and quantity.

Read them as a rule rather than four pictures: a demand shift moves price and quantity the same way; a supply shift moves them opposite ways. Which way is decided by whether the curve moved right (more at every price) or left.

Both curves shift. Now one of the two outcomes is determinate from the directions alone and the other depends on how far each curve moved.

On the exam, “indeterminate” is a full-credit answer when you say why: “price could rise, fall, or stay the same, depending on the relative sizes of the shifts.” Guessing a direction is the way to lose the point. If the prompt gives magnitudes, the numbers decide, and Problem 6(c) is a case where they land the price exactly where it started.

Surplus moves with the shift. A rightward demand shift raises price and quantity, so producer surplus rises for certain; consumer surplus usually rises too, because the shift itself means buyers value the good more. A rightward supply shift lowers price and raises quantity, so consumer surplus rises for certain. How much price moves depends on elasticity: the same demand shift raises price more against a steep, inelastic supply than against a flat one, because sellers cannot expand to meet it. Problem 6(d) puts numbers on that.

GOVERNMENT INTERVENTION: PRICE CONTROLS, TAXES, SUBSIDIES

Every intervention on this card holds the market away from the quantity where the curves cross, and the cost of doing so has the same name each time: deadweight loss, the surplus from the trades that no longer happen. Read every case in the same order — where is the new quantity, what price do buyers pay, what price do sellers keep, and which areas changed.

A price ceiling is a legal maximum. It binds only if it is below the equilibrium price; a ceiling above equilibrium changes nothing. Binding, it creates a shortage: at the low price buyers want more and sellers offer less, and the quantity that actually trades is the smaller number, $Q_s$. Rent control is the exam’s favorite example.

A price floor is a legal minimum. It binds only if it is above equilibrium, and then creates a surplus: sellers offer more than buyers take, and the quantity traded is $Q_d$. A minimum wage is the example, with labor as the good.

In both pictures the quantity traded fell from 16, and the hatched triangle is the surplus those lost trades would have created. Some surplus also moved: under the ceiling, buyers who still get the good pay less, so a rectangle of producer surplus became consumer surplus; under the floor, the reverse. Problem 7 computes every area.

A per-unit tax drives a wedge between what buyers pay and what sellers keep, equal to the tax. Draw it as a shift of the taxed side’s curve by the amount of the tax: a tax on sellers shifts supply up by $t$ (sellers need $t$ more per unit); a tax on buyers shifts demand down by $t$. Either way the market lands in the same place — statutory incidence, who writes the check, does not decide economic incidence, who bears the cost. Then:

A per-unit subsidy is the tax run backwards: supply shifts down by the subsidy, quantity rises past the efficient one, buyers pay less and sellers receive more, and the gap between them is the subsidy. The cost to the government is the rectangle subsidy $\times$ new quantity — the area 92% of students could not shade in 2025. Buyers and sellers gain, but less than the subsidy costs, and the shortfall is the deadweight loss: the extra units cost more to make than they were worth.

Quantity controls. A quota caps the quantity below the equilibrium one; price rises to what buyers will pay for that smaller quantity, and the surplus from the lost trades is deadweight loss. The Course and Exam Description keeps the graphing of quotas out of scope but the quantity reasoning in.

The line that earns the efficiency point. A tax, a subsidy, a ceiling, a floor or a quota placed on a market that was producing the efficient quantity reduces allocative efficiency when it changes quantity away from that efficient level. First check whether the policy binds and whether quantity changes. A nonbinding price control has no effect; deadweight loss measures surplus lost on affected trades.

INTERNATIONAL TRADE: A WORLD PRICE, AND A TARIFF

Autarky is the closed economy: the domestic equilibrium of the earlier cards. Opening to trade means the domestic price becomes the world price, drawn as a horizontal line, and the gap between what domestic buyers want and domestic sellers offer at that price is filled by trade.

A tariff is a tax on imports. It raises the domestic price by the tariff, so domestic sellers offer more and domestic buyers take less: the import gap shrinks. Read the areas in this order — consumer surplus falls (the price rose); producer surplus rises (domestic sellers sell more at more); the government collects tariff $\times$the imports that remain, the rectangle over the gap; and two hatched triangles are deadweight loss, one for the units now made at home at more than the world price, one for the units buyers no longer buy. Problem 9 computes all five.

A quota limits the import quantity directly. It raises the domestic price the same way a tariff of the right size would, but the rectangle goes to whoever holds the import licenses rather than to the government. The Course and Exam Description keeps the quota’s graph out of scope and its quantity effect in.