AP Microeconomics Unit 2: How Markets Work with Supply, Demand, and Elasticity

Demand

What demand is (and what it is not)

Demand is a relationship showing how much of a good or service consumers are willing and able to buy at each possible price, holding other relevant factors constant (this “holding constant” idea is called ceteris paribus). Demand is not a single number—it’s an entire schedule (or curve) connecting prices to quantities.

A crucial distinction in AP Micro is the difference between:

  • Quantity demanded: one specific amount at one specific price (a point on the curve).
  • Demand: the whole curve (or schedule) across all prices.

This matters because many questions test whether you can tell the difference between a movement along the demand curve (caused by price changing) and a shift of the demand curve (caused by something other than the good’s own price).

Why demand matters

Demand is half of the market mechanism. When you pair demand with supply, you can predict:

  • Equilibrium price and quantity (where the market “settles”)
  • Shortages and surpluses (when price is “wrong”)
  • How external changes (income, tastes, population, etc.) ripple through markets

In real life, demand helps explain why concert tickets sell out, why higher gasoline prices reduce driving over time, and why “must-have” products can stay expensive without losing many buyers.

The law of demand and the logic behind it

The law of demand states that, all else equal, as price rises, quantity demanded falls; as price falls, quantity demanded rises. Graphically, the demand curve slopes downward.

Why does this happen?

  1. Substitution effect: When a good becomes more expensive, people switch toward substitutes.
  2. Income effect: When price rises, your purchasing power falls; you can afford less.

A common misconception: students sometimes explain the law of demand using “demand decreases when price increases.” That wording can be wrong on AP exams. If price changes, you usually say quantity demanded changes, not demand.

Building a demand schedule and graph

A demand schedule lists prices and the corresponding quantities demanded. Plotting these points gives the demand curve.

When you move from a higher price to a lower price on the same curve, you are not changing demand—you are changing quantity demanded.

Shifters of demand (what moves the whole curve)

A shift in demand means that at every price, consumers now want to buy a different quantity. These are the classic demand shifters (often remembered as “NIFTY”):

  1. Number of buyers: More consumers typically increases demand.
  2. Income:
    • Normal goods: demand increases when income increases.
    • Inferior goods: demand decreases when income increases.
  3. Future expectations: If buyers expect higher future prices (or scarcity), demand today rises.
  4. Tastes and preferences: Trends, advertising, and changing preferences shift demand.
  5. Prices of related goods:
    • Substitutes: If the price of a substitute rises, demand for this good increases.
    • Complements: If the price of a complement rises, demand for this good decreases.

Example (shifts vs movement):

  • If the price of coffee rises, you move along the demand curve for coffee: quantity demanded falls.
  • If the price of tea (a substitute) rises, the demand curve for coffee shifts right: people want more coffee at every coffee price.

Market demand vs individual demand

Individual demand is one consumer’s willingness and ability to buy. Market demand is the horizontal sum of all individual demands—add quantities at each price.

This comes up when an exam question gives two consumers’ schedules and asks you to construct the market demand schedule.

Demand, equilibrium, and market adjustment (connecting to supply)

Demand alone doesn’t set the market price; it interacts with supply.

  • If demand increases (shifts right) and supply is unchanged, equilibrium price and equilibrium quantity both typically rise.
  • If demand decreases (shifts left) and supply is unchanged, equilibrium price and quantity typically fall.

You should be able to reason through these outcomes without memorizing: more willingness to buy pushes competition among buyers, bidding price up.

Worked example: identifying a demand shift

Suppose burgers and fries are complements. The price of fries rises.

  • Because fries are more expensive, fewer people buy fries.
  • Because fries and burgers are often consumed together, fewer people want burgers at each burger price.
  • Result: demand for burgers shifts left.

Notice: the price that changed was fries (a related good), not burgers. That’s why this is a shift, not a movement along the burger demand curve.

Exam Focus
  • Typical question patterns:
    • Given a scenario, identify whether it causes a movement along demand or a shift of demand, and which direction.
    • Determine the effect of a demand shift on equilibrium price and quantity (with supply held constant).
    • Classify goods as normal vs inferior, or related goods as substitutes vs complements, using the direction of demand shifts.
  • Common mistakes:
    • Saying “demand falls” when price rises (it’s usually quantity demanded falling).
    • Mixing up substitutes and complements (use the “move together” idea: complements move together; substitutes move opposite).
    • Forgetting ceteris paribus: attributing a shift to a price change of the same good.

Supply

What supply is (and what it is not)

Supply is a relationship showing how much producers are willing and able to sell at each possible price, holding other factors constant. Like demand, supply is not a single point—it’s a full schedule or curve.

Again, separate:

  • Quantity supplied: one amount at one price (a point on the curve).
  • Supply: the entire curve.

Why supply matters

Supply represents the production side of markets. Understanding supply helps you predict how firms respond to incentives:

  • Higher prices can make production more profitable, leading to more output.
  • Higher input costs can squeeze profits, reducing output.

Supply also helps explain price spikes (like after natural disasters) and why technological improvements can make products cheaper over time.

The law of supply and the logic behind it

The law of supply states that, all else equal, as price rises, quantity supplied rises; as price falls, quantity supplied falls. The supply curve slopes upward.

Why does this happen?

  • Increasing opportunity cost: To produce more, firms often must use resources that are less well-suited, pay overtime, or bid resources away from other uses.
  • Profit incentive: Higher market prices can make it worthwhile to expand output.

A common misconception is thinking supply slopes upward because “it costs more to make more.” That can be part of the story, but AP Micro typically wants the opportunity cost/profit-incentive logic, not just “costs rise.”

Shifters of supply (what moves the whole curve)

A shift in supply means that at every price, producers now want to sell a different quantity.

Key supply shifters include:

  1. Input prices: Higher wages, rent, or materials costs typically decrease supply (shift left).
  2. Technology / productivity: Better technology increases supply (shift right).
  3. Number of sellers: More firms in the market increases supply.
  4. Taxes and subsidies:
    • A tax on producers increases costs, decreasing supply.
    • A subsidy lowers effective costs, increasing supply.
  5. Expectations: If sellers expect higher future prices, they may reduce supply today (holding inventory).
  6. Prices of related goods in production:
    • If resources can produce either Good A or Good B, a higher price for Good B can reduce supply of Good A (firms switch production).
  7. Natural events (weather, disasters): Often decrease supply by disrupting production.

Supply, equilibrium, and market adjustment (connecting to demand)

Supply shifts change equilibrium outcomes.

  • If supply increases (shifts right) with demand constant, equilibrium price typically falls and equilibrium quantity rises.
  • If supply decreases (shifts left) with demand constant, equilibrium price rises and equilibrium quantity falls.

The intuition: more available output increases competition among sellers, pushing price down.

Shortage and surplus (and why markets move toward equilibrium)

When the market price is not at equilibrium:

  • Shortage occurs when price is below equilibrium: quantity demanded exceeds quantity supplied.
  • Surplus occurs when price is above equilibrium: quantity supplied exceeds quantity demanded.

Market pressure tends to fix these (assuming flexible prices):

  • Shortage leads to upward pressure on price (buyers compete).
  • Surplus leads to downward pressure on price (sellers compete).

This adjustment story is frequently tested: you are expected to label shortages/surpluses correctly and describe how price changes to eliminate them.

Worked example: a supply decrease

A drought reduces the wheat harvest.

  • Wheat output becomes harder/costlier to produce.
  • At any given price, farmers can bring less wheat to market.
  • Result: supply of wheat shifts left.
  • With demand unchanged, equilibrium price rises and equilibrium quantity falls.
Exam Focus
  • Typical question patterns:
    • Identify whether a scenario changes quantity supplied (movement) or shifts supply, and which direction.
    • Predict new equilibrium price and quantity after a supply shift (with demand held constant).
    • Explain shortages and surpluses at a given price and the direction of price adjustment.
  • Common mistakes:
    • Saying “supply increases because price increased” when the scenario is actually a non-price shifter (that would be a shift).
    • Confusing a change in supply with a change in quantity supplied.
    • Reversing shortage vs surplus (anchor yourself: shortage means buyers want more than sellers provide).

Elasticity of Demand and Supply

What elasticity measures

Elasticity measures how responsive one variable is to a change in another variable—in Unit 2, the big idea is responsiveness of quantity to price.

In markets, responsiveness matters because it tells you how much behavior changes when incentives change. Two markets can both obey the law of demand, but one may react strongly to a price change while another barely reacts.

A major misconception is confusing slope with elasticity:

  • Slope depends on the units on the axes (dollars per unit).
  • Elasticity is unit-free because it uses percentages.

That’s why elasticity is the standard tool for comparing responsiveness across different goods.

Price elasticity of demand (PED)

Price elasticity of demand measures how sensitive quantity demanded is to a change in the good’s own price.

Formula (using percent changes):

E_d = \frac{\%\Delta Q_d}{\%\Delta P}

Where:

  • E_d is price elasticity of demand
  • \%\Delta Q_d is the percent change in quantity demanded
  • \%\Delta P is the percent change in price

Because of the law of demand, \%\Delta Q_d and \%\Delta P usually have opposite signs, so E_d is often negative. In AP Micro, it’s common to report elasticity in absolute value (as a positive number) and focus on magnitude:

  • Elastic demand: absolute value of E_d is greater than 1 (quantity responds strongly).
  • Inelastic demand: absolute value of E_d is less than 1 (quantity responds weakly).
  • Unit elastic: absolute value of E_d equals 1.
Midpoint method (avoids direction and base problems)

A frequent exam skill is calculating elasticity using the midpoint method, which uses the average of the starting and ending values.

Percent change in quantity (midpoint):

\%\Delta Q = \frac{Q_2 - Q_1}{\frac{Q_1 + Q_2}{2}}

Percent change in price (midpoint):

\%\Delta P = \frac{P_2 - P_1}{\frac{P_1 + P_2}{2}}

Then:

E_d = \frac{\%\Delta Q}{\%\Delta P}

The midpoint method matters because if you go from point A to B or from B to A, you get the same elasticity magnitude.

Determinants of PED (what makes demand more or less elastic)

Elasticity is largely about how easily consumers can adjust.

  • Availability of close substitutes: More substitutes makes demand more elastic.
  • Necessities vs luxuries: Necessities tend to be inelastic; luxuries tend to be elastic.
  • Share of income: If it takes a big chunk of income, consumers pay attention and adjust more.
  • Time horizon: Demand is usually more elastic in the long run because people have more time to find alternatives.

A subtle but important point: “Time” doesn’t change preferences automatically; it changes the ability to respond (find substitutes, change habits, buy different durable goods).

Total revenue test (linking elasticity to seller outcomes)

Total revenue (TR) is the money sellers receive from sales:

TR = P \times Q

Elasticity tells you what happens to total revenue when price changes:

  • If demand is elastic, a price increase causes TR to fall (quantity falls proportionally more).
  • If demand is inelastic, a price increase causes TR to rise (quantity falls proportionally less).
  • If demand is unit elastic, TR stays about the same.

This is tested conceptually and numerically. The intuition: with elastic demand, consumers are very responsive, so raising price backfires.

Worked example: PED with midpoint method

Price rises from 10 to 12, and quantity demanded falls from 100 to 80.

1) Compute midpoint percent change in quantity:

\%\Delta Q = \frac{80 - 100}{\frac{100 + 80}{2}} = \frac{-20}{90} = -0.2222

2) Compute midpoint percent change in price:

\%\Delta P = \frac{12 - 10}{\frac{10 + 12}{2}} = \frac{2}{11} = 0.1818

3) Elasticity:

E_d = \frac{-0.2222}{0.1818} = -1.2222

In absolute value, |E_d| \approx 1.22, so demand is elastic.

Income elasticity of demand (normal vs inferior, plus “how much”)

Income elasticity of demand measures how quantity demanded changes when consumer income changes.

E_I = \frac{\%\Delta Q_d}{\%\Delta I}

Where I is income.

  • If E_I > 0, the good is normal.
  • If E_I < 0, the good is inferior.

This goes beyond classification: a high positive income elasticity suggests a “more luxury-like” good (demand grows strongly with income), while a small positive value suggests a necessity.

Cross-price elasticity of demand (substitutes vs complements, plus “how close”)

Cross-price elasticity of demand measures how quantity demanded of one good changes when the price of another good changes.

E_{xy} = \frac{\%\Delta Q_x}{\%\Delta P_y}

  • If E_{xy} > 0, goods x and y are substitutes.
  • If E_{xy} < 0, they are complements.
  • If E_{xy} \approx 0, they are likely unrelated.

Magnitude matters: a larger absolute value suggests a stronger relationship (closer substitutes or stronger complements).

Price elasticity of supply (PES)

Price elasticity of supply measures how responsive quantity supplied is to a change in price.

E_s = \frac{\%\Delta Q_s}{\%\Delta P}

Supply elasticity is heavily influenced by production flexibility:

  • Time is often the biggest determinant. In the very short run, firms may have fixed capacity, making supply inelastic. Over longer periods, firms can build factories, enter/exit markets, and adjust, making supply more elastic.
  • Availability of inputs: If inputs are specialized or scarce, supply tends to be less elastic.
  • Ease of storing the product: If a product is storable, sellers can adjust timing of sales, which can increase responsiveness.

A frequent misunderstanding: students assume supply is always elastic “because firms want profit.” Wanting profit doesn’t mean you can instantly produce more—capacity constraints matter.

Worked example: PES with midpoint method

Price rises from 20 to 30 and quantity supplied rises from 200 to 260.

1) Midpoint percent change in quantity:

\%\Delta Q = \frac{260 - 200}{\frac{200 + 260}{2}} = \frac{60}{230} = 0.2609

2) Midpoint percent change in price:

\%\Delta P = \frac{30 - 20}{\frac{20 + 30}{2}} = \frac{10}{25} = 0.4

3) Elasticity:

E_s = \frac{0.2609}{0.4} = 0.6523

Since E_s < 1, supply is inelastic over this range (quantity supplied responds, but not strongly).

Elasticity on graphs (steep vs flat, and why that’s not the whole story)

Graphically:

  • A more elastic curve looks flatter.
  • A more inelastic curve looks steeper.

But don’t reduce elasticity to “steep means inelastic” without context. Elasticity varies along a straight-line demand curve: at high prices and low quantities, demand is more elastic; at low prices and high quantities, demand is more inelastic. That’s because elasticity depends on percentage changes, and the same absolute change can be a different percentage depending on the starting point.

Elasticity and market outcomes (why the concept is tested so often)

Elasticity is a bridge between basic supply-and-demand graphs and real policy/business questions:

  • A firm deciding whether raising price will increase revenue needs PED.
  • A government predicting how a tax affects quantity bought/sold and revenue needs PED and PES.
  • Understanding why some markets experience large price swings after shocks often depends on inelastic supply or demand.

Even if taxes and price controls are covered elsewhere in Unit 2, elasticity is the tool that explains why those policies have different effects across markets.

Exam Focus
  • Typical question patterns:
    • Calculate PED or PES using the midpoint method from two points (often from a table or graph).
    • Use elasticity to predict the effect of a price change on total revenue.
    • Interpret income and cross-price elasticity signs to classify normal/inferior goods and substitutes/complements.
  • Common mistakes:
    • Confusing slope with elasticity (elasticity uses percentages; slope uses units).
    • Forgetting midpoint method averages (using the initial value instead leads to different answers depending on direction).
    • Misreading the total revenue test (for elastic demand, price and TR move in opposite directions; for inelastic demand, they move together).