Supply and Demand

The law of demand says people buy less of a good when its price rises. On a graph with price on the vertical axis and quantity on the horizontal axis, the demand curve slopes down; the income and substitution effects and diminishing marginal utility explain why. A change in the good's own price moves you along the curve. Changes in tastes, income, prices of related goods, expectations or the number of buyers shift the whole curve.

The law of supply says a higher price leads sellers to offer more, so the supply curve slopes up. Market supply adds up every seller's supply. A change in the good's own price moves you along the curve. Changes in input prices, technology, taxes or subsidies, expectations, prices of other goods the seller could make, or the number of sellers shift the whole curve.

Price elasticity of demand = % change in quantity demanded ÷ % change in price, ignoring the minus sign. Above 1 is elastic, below 1 is inelastic and exactly 1 is unit elastic, and demand is more elastic when there are more substitutes. Elasticity predicts revenue: with elastic demand a price cut raises total revenue, and with inelastic demand a price rise does. Elasticity changes along a straight-line demand curve, so slope is not the same as elasticity.

Price elasticity of supply = % change in quantity supplied ÷ % change in price. Supply is elastic above 1, inelastic below 1 and unit elastic at exactly 1. Supply is usually more elastic when sellers can easily get or switch inputs and when they have more time to adjust.

Income elasticity of demand = % change in quantity demanded ÷ % change in income. It's positive for a normal good and negative for an inferior good. Cross-price elasticity = % change in quantity demanded of one good ÷ % change in the price of another good. It's positive for substitutes, negative for complements and zero when the goods are unrelated.

Equilibrium is where the downward-sloping demand curve crosses the upward-sloping supply curve, so quantity demanded equals quantity supplied. Consumer surplus is the area below the demand curve and above the price, and producer surplus is the area above the supply curve and below the price. In a competitive market with no market failures, equilibrium makes their total (total surplus) as large as possible.

If the price is above equilibrium there's a surplus (more is supplied than demanded), and the price tends to fall. If it's below, there's a shortage and the price tends to rise. An increase in demand (a rightward shift) raises both price and quantity, and an increase in supply (a rightward shift) lowers price and raises quantity. When both curves shift at once, you can predict the change in price or in quantity, but not both, unless you know the sizes of the shifts.

A binding price ceiling (set below equilibrium) causes a shortage, and a binding price floor (set above equilibrium) causes a surplus; both create deadweight loss. A per-unit tax on sellers shifts supply up by the amount of the tax. Buyers pay more, sellers keep less, and the government collects the tax times the new quantity. Deadweight loss is the triangle between the demand curve and the original supply curve, from the new quantity out to the old one. Whichever side is less elastic (less able to react to the price) bears more of the tax. A per-unit subsidy shifts supply down, so output rises past the efficient amount, which also creates deadweight loss.

When a country opens to trade, its domestic price moves from the autarky price (the price with no trade) to the world price, and trade fills the gap between what's demanded and what's supplied at home. If the world price is below the autarky price, the country imports, consumers gain and domestic producers lose; if it's above, the country exports. Either way, total surplus rises. A tariff raises the domestic price, so imports and consumer surplus fall, domestic producers sell more, the government collects revenue and deadweight loss appears. An import quota has similar effects on price and surplus, but the government collects no tariff revenue.