AP Microeconomics Unit 2: Market Dynamics & Elasticity

Unit 2: Supply and Demand

This unit establishes the fundamental models used in Microeconomics. It covers how consumers and producers interact in a market, how prices are determined, and how markets respond to changes in external factors or government policies.

2.1 Demand

Demand refers to the different quantities of goods/services that consumers are willing and able to purchase at different prices at a specific time.

The Law of Demand

There is an inverse relationship between price and quantity demanded.

  • As Price ($P$) $\uparrow$, Quantity Demanded ($Q_d$) $\downarrow$
  • As Price ($P$) $\downarrow$, Quantity Demanded ($Q_d$) $\uparrow$
  • Graphically: This creates a downward sloping Demand curve.

Why is the Demand Curve Downward Sloping?

Three specific concepts explain this negative slope:

  1. The Substitution Effect: As the price of Good A increases, it becomes relatively more expensive compared to Good B. Consumers switch to the cheaper substitute, decreasing the quantity demanded of Good A.
  2. The Income Effect: As the price of a good decreases, the consumer's purchasing power increases. They feel richer and can buy more of the good (assuming it is a normal good).
  3. Law of Diminishing Marginal Utility: As you consume more units of a specific good, the additional satisfaction (utility) from each successive unit decreases. Therefore, you are only willing to buy more units if the price is lower.

Changes in Quantity Demanded vs. Shifts in Demand

It is crucial to distinguish between a movement along the curve and a shift of the curve.

  • Change in Quantity Demanded: Caused ONLY by a change in the product's own price. This is a movement along the curve.
  • Change in Demand: Caused by non-price determinants (shifters). This results in a shift of the entire curve (Left = Decrease, Right = Increase).

Demand Curve demonstrating movement vs shift

Determinants of Demand (Shifters)

Remember the mnemonic MERIT or TRIBE:

  1. Tastes and Preferences: Positive trends shift demand right; negative reports shift left.
  2. Related Goods (Prices of):
    • Substitutes: Goods used in place of one another (e.g., Coffee vs. Tea). If Price of Coffee $\uparrow$, Demand for Tea $\uparrow$ (Direct relationship).
    • Complements: Goods bought together (e.g., PB & Jelly). If Price of PB $\uparrow$, Demand for Jelly $\downarrow$ (Inverse relationship).
  3. Income:
    • Normal Goods: Income $\uparrow$ $\rightarrow$ Demand $\uparrow$ (e.g., New cars, steak).
    • Inferior Goods: Income $\uparrow$ $\rightarrow$ Demand $\downarrow$ (e.g., Ramen noodles, used clothes).
  4. Buyers (Number of): More population/buyers shifts demand right.
  5. Expectations: If you expect prices to rise next week, your demand increases today.

2.2 Supply

Supply refers to the textual quantities of goods/services that willing and able sellers are prepared to produce/sell at different prices.

The Law of Supply

There is a direct relationship between price and quantity supplied.

  • As Price ($P$) $\uparrow$, Quantity Supplied ($Q_s$) $\uparrow$
  • As Price ($P$) $\downarrow$, Quantity Supplied ($Q_s$) $\downarrow$
  • Graphically: This creates an upward sloping Supply curve.

Reasons for the Law of Supply

  1. Profit Incentive: Higher prices signal higher potential profit, encouraging firms to produce more.
  2. Increasing Marginal Costs: To produce more, firms often incur higher costs per unit (overtime pay, less efficient resources). Hence, they need a higher price to cover the cost.

Supply Curve demonstrating movement vs shift

Determinants of Supply (Shifters)

Remember the mnemonic TRICE or ROTTEN:

  1. Technology: Better tech increases efficiency, lowering costs and shifting supply Right.
  2. Related Goods (Prices of): If a producer can sell wheat for more than corn, they shift resources to wheat, so the supply of corn shifts Left.
  3. Inputs (Resource Costs): If the cost of labor, raw materials, or energy increases, supply shifts Left.
  4. Competition (Number of Sellers): More firms entering the market shifts supply Right.
  5. Expectations: If producers expect prices to rise later, they may withhold supply now (Shift Left) to sell later.
  6. Government Action:
    • Taxes: Treated as an input cost. Excise taxes shift supply Left.
    • Subsidies: