Unit 2: Supply and Demand

These supply-and-demand tools are the foundation for most of what comes later in AP Microeconomics. The key skills are (1) knowing when a change causes a movement along a curve vs a shift of a curve, and (2) predicting how equilibrium, surplus/shortage, and welfare measures change.

Demand: How Buyers Behave

What demand means (and what it does not mean)

Demand is the relationship between the price of a good and the quantity that consumers are willing and able to buy at each price, holding other factors constant.

That “willing and able” phrase matters: wanting a new laptop doesn’t count as demand if you cannot pay for it. Demand is not just “popularity”; it is a measurable link between price and quantity purchased.

Economists visualize demand with either a demand schedule (a table of prices and quantities) or a demand curve (a graph of those points).

The law of demand and why the curve slopes downward

The law of demand says that, all else equal, when the price of a good rises, the quantity demanded falls, and when price falls, quantity demanded rises.

A demand curve slopes downward for three closely related reasons:

1. Substitution effect: when the price of a good rises, buyers tend to switch toward relatively cheaper substitutes.
2. Income effect: when the price rises, your purchasing power effectively falls (your income buys less), so you buy less of some goods.
3. Law of diminishing marginal utility: as more units of a product are consumed, the additional satisfaction (utility) from extra units tends to decline. Consumers will only buy additional units if the price is low enough to match that lower extra utility.

A concrete diminishing-marginal-utility intuition: Apple users might buy a phone, but they would not buy a new iPhone every month at high prices because an extra phone provides little (or less) additional utility.

A common misconception is: “If the price goes up, demand goes up because sellers make more money.” That confuses demand (buyers) with supply (sellers), and it confuses a movement along the curve with a shift of the curve.

Individual demand vs. market demand

• Individual demand shows one consumer’s relationship between price and quantity.
• Market demand is the horizontal sum of all individual demands (add quantities at each price).

Determinants of demand (what shifts the curve)

A change in the good’s own price causes a movement along the demand curve (a change in quantity demanded). Anything else that changes causes a shift in demand (a change in demand).

Key determinants of demand (shifters) include:

1. Preferences/tastes: If a product becomes more fashionable or desirable, demand increases.
2. Income:
   • Normal good: demand rises when income rises (example: Oreos).
   • Inferior good: demand rises when income falls, and demand falls when income rises (example: off-brand Oreos).
3. Prices of related goods:
   • Substitutes: goods/services that can be used in place of another (e.g., coffee and tea). If the price of tea rises, demand for coffee increases.
   • Complements: goods/services consumed together (e.g., hamburgers and buns; printers and ink). If the price of printers rises, demand for ink decreases.
4. Expectations (including expectations about future prices, future income, or even negative future events like product problems/“failure” that change current buying behavior):
   • If you expect higher future prices, you may buy more now (current demand increases).
   • If you expect higher future income, you may buy more now.
5. Number of buyers: more consumers generally increases market demand.

A quick way to keep substitutes vs. complements straight:

• Substitutes “replace” each other.
• Complements “go together.”

“Change in demand” vs. “change in quantity demanded”

This distinction is one of the most-tested skills in Unit 2.

• Change in quantity demanded: caused only by a change in the good’s price; it’s a movement along the same demand curve.
• Change in demand: caused by a determinant (income, tastes, related goods, expectations, number of buyers); it shifts the entire curve.

Example: identifying a shift vs. a movement

Suppose the price of hamburgers rises. Consumers buy fewer hamburgers. That is a decrease in quantity demanded (move up along the demand curve).

Now suppose the price of hot dogs (a substitute) rises. Many consumers switch to hamburgers at every hamburger price. That is an increase in demand (demand curve shifts right).

Exam Focus

• Typical question patterns:
  • Identify whether a scenario causes a shift in demand or a movement along demand.
  • Determine whether demand increases or decreases given a change in income and whether the good is normal or inferior.
  • Predict the effect of a change in the price of a related good (substitute vs complement).
• Common mistakes:
  • Saying “demand increased” when the scenario only describes a higher quantity bought due to a lower price.
  • Mixing up substitutes and complements (draw a quick relationship: substitutes move together in quantity, complements move opposite).
  • Forgetting “holding other factors constant” and changing multiple things at once without isolating the ceteris paribus effect.

Supply: How Sellers Behave

What supply means

Supply is the relationship between the price of a good and the quantity that producers are willing and able to sell at each price, holding other factors constant.

Supply is a full schedule or curve, not a single quantity. The market supply shows the quantity sellers are willing and able to offer at various prices at a given time.

The law of supply and why the curve slopes upward

The law of supply says that, all else equal, when the price of a good rises, the quantity supplied rises, and when price falls, quantity supplied falls.

Two core reasons explain this direct relationship:

• Higher prices increase profitability. Firms are willing to produce more output, and firms that were not profitable at lower prices may enter the market.
• Marginal cost tends to rise as output rises. Producing additional units often requires using less-efficient resources or paying overtime, so charging higher prices provides a way to cover higher marginal costs.

A key precision point: when the price rises, that causes an increase in quantity supplied (movement along). A supply increase is a rightward shift due to a non-price factor.

Individual supply vs. market supply

• Individual supply is one firm’s supply curve.
• Market supply is the horizontal sum of all firms’ supplies.

Determinants of supply (what shifts the curve)

Supply shifts when production conditions change.

Key determinants of supply (shifters):

1. Input prices / resource costs and availability (land, labor, capital, raw materials, energy): higher input prices reduce supply.
2. Technology: better technology usually increases supply by lowering costs and improving efficiency (e.g., production-line machines reducing unit costs).
3. Taxes and subsidies:
   • A per-unit tax tends to decrease supply (raises per-unit cost).
   • A subsidy tends to increase supply (lowers effective per-unit cost).
4. Number of sellers: more firms increases market supply, often increasing competition and giving consumers more choices at lower prices.
5. Expectations: if firms expect higher prices later, they may reduce current supply (hold inventory) to sell later for more (and vice versa).
6. Regulation and policy: costly compliance can reduce supply; deregulation can increase supply.
7. Prices of related goods in production (other goods and services):
   • If a producer can switch between products (substitutes in production), a higher price for one product can increase its supply while reducing the supply of the other.
   • Example: if a farmer can grow corn or wheat and the price of wheat rises relative to corn, the farmer may switch acreage to wheat. Wheat supply increases (shifts right) and corn supply decreases (shifts left).

Example: shifting supply

If the price of microchips (an input for computers) rises, computer manufacturers face higher costs. At every computer price, they are willing to produce fewer computers. Supply shifts left.

Exam Focus

• Typical question patterns:
  • Identify whether a situation changes supply (shift) or quantity supplied (movement along).
  • Predict direction of supply shift given an input price change, a technology change, or a tax/subsidy.
  • Compare short-run vs long-run supply responsiveness when production can adjust over time.
• Common mistakes:
  • Treating “price increased” as a shifter of supply rather than a movement along.
  • Confusing a cost increase with increased supply (cost increases shift supply left).
  • Forgetting that market supply depends on entry/exit (number of sellers).

Market Equilibrium, Disequilibrium, and Changes in Equilibrium

What equilibrium is and why it matters

A market is in equilibrium when the quantity demanded equals the quantity supplied.

Q_d = Q_s

Equilibrium is the price and quantity that tend to persist in a competitive market with flexible prices because the plans of buyers and sellers are mutually consistent. Another way to say it: equilibrium occurs when no one is better off doing something else, given the market conditions.

Shortages and surpluses (and the adjustment process)

When the market price is not at equilibrium:

• Shortage occurs if

Q_d > Q_s

Buyers compete for limited goods, pushing price up.

• Surplus occurs if

Q_s > Q_d

Sellers compete to get rid of unsold goods, pushing price down.

An AP essential is explaining the incentives: shortages create upward pressure on price; surpluses create downward pressure on price.

Solving for equilibrium with tables, graphs, or equations

If given equations:

1. Set

Q_d = Q_s

2. Solve for equilibrium price.
3. Substitute back to find equilibrium quantity.

Example (equilibrium with equations)
Suppose:

Q_d = 100 - 2P

Q_s = 10 + 3P

Set equal:

100 - 2P = 10 + 3P

90 = 5P

P = 18

Now find quantity:

Q = 100 - 2(18) = 64

So equilibrium is P = 18 and Q = 64.

Comparative statics: predicting new equilibrium after shifts

Most real changes come from a demand shift, a supply shift, or both.

• Demand increases (right shift): equilibrium price rises, equilibrium quantity rises.
• Demand decreases (left shift): equilibrium price falls, equilibrium quantity falls.
• Supply increases (right shift): equilibrium price falls, equilibrium quantity rises.
• Supply decreases (left shift): equilibrium price rises, equilibrium quantity falls.

Double shifts and ambiguity

With a simultaneous shift in both demand and supply, either price or quantity will be indeterminate (ambiguous) unless you know which shift is larger.

A reliable method:

1. Identify which curve(s) shift and in which direction.
2. Shift one curve at a time on your mental graph.
3. Conclude what happens to equilibrium P and Q.

Key insight: With two shifts, one variable may be ambiguous.

• If both demand and supply increase: quantity definitely increases, price is ambiguous.
• If demand increases and supply decreases: price definitely increases, quantity is ambiguous.

Example: ambiguous case
If demand increases (right) and supply increases (right), quantity increases for sure, but price depends on which shift is larger.

Exam Focus

• Typical question patterns:
  • Given a change (tastes, income, input costs), draw the shift and identify changes in equilibrium P and Q.
  • Identify shortage/surplus at a given price and explain how price changes over time.
  • Solve equilibrium algebraically from linear demand and supply equations.
  • Recognize when a double shift makes either equilibrium price or equilibrium quantity ambiguous.
• Common mistakes:
  • Shifting curves in the wrong direction (especially for complements/substitutes and input costs).
  • Forgetting that price and quantity can be ambiguous when both curves shift.
  • Labeling equilibrium quantity as “demand” or “supply” rather than the intersection outcome.

Elasticity: Measuring Responsiveness

What elasticity is and why it matters

Elasticity measures how responsive one variable is to a change in another variable, usually in percentage terms.

In Unit 2, elasticity helps predict:

• how much quantity changes when price changes,
• how total revenue changes when price changes,
• who bears the burden of a tax,
• how severe shortages/surpluses become under price controls.

Elasticity is about percent change, not raw change.

Price elasticity of demand (PED)

The price elasticity of demand measures how much quantity demanded responds to a price change:

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

Because demand slopes downward, E_d is usually negative; AP Micro often discusses elasticity using the absolute value.

Classification (in absolute value):

• Elastic: greater than 1
• Inelastic: less than 1
• Unit elastic: equals 1
• Perfectly inelastic: equals 0 (vertical curve)
• Perfectly elastic: infinite (horizontal curve)

The midpoint method (to avoid direction problems)

Midpoint percent change in quantity:

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

Midpoint percent change in price:

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

Then:

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

Worked example (midpoint PED)
Price rises from 10 to 12, and quantity demanded falls from 100 to 80.

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

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

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

In absolute value terms, demand is elastic.

What determines whether demand is elastic or inelastic?

Major determinants:

• Availability of close substitutes: more substitutes makes demand more elastic.
• Necessity vs. luxury: necessities tend to be inelastic; luxuries tend to be elastic.
• Share of budget: expensive items take a larger share and tend to be more elastic.
• Time horizon: demand is usually more elastic in the long run.

A frequent misunderstanding is to treat “many buyers” as a determinant of elasticity. The number of buyers shifts demand, but does not automatically change responsiveness.

You can also recognize common curve/market characteristics:

• Characteristics of elastic demand: flatter, quantity is sensitive to price change, many substitutes, luxury items, large portion of income, not needed immediately.
• Characteristics of inelastic demand: steeper, few substitutes, required now, small portion of income.

Total revenue and elasticity

Total revenue:

TR = P \times Q

Elasticity predicts how TR changes when price changes:

• If demand is elastic, price and total revenue move in opposite directions.
• If demand is inelastic, price and total revenue move in the same direction.
• If unit elastic, total revenue stays roughly constant.

Example (elastic vs. inelastic TR)

• Elastic case: a 10% price increase causes a 30% quantity decrease, so TR falls.
• Inelastic case: a 10% price increase causes a 3% quantity decrease, so TR rises.

Elasticity along a linear demand curve

Along a straight-line demand curve, elasticity is not constant:

• Upper-left (high price, low quantity) is more elastic.
• Lower-right (low price, high quantity) is more inelastic.
• The midpoint is unit elastic.

Cross-price elasticity of demand

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

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

Interpretation:

• If E_{xy} > 0: goods are substitutes.
• If E_{xy} < 0: goods are complements.

Income elasticity of demand

Income elasticity measures responsiveness of demand to income:

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

Interpretation:

• If E_I > 0: normal good.
• If E_I < 0: inferior good.

A common additional classification:

• If income elasticity is greater than 1, demand is income elastic.
• If income elasticity is less than 1 (but positive), demand is income inelastic.

Price elasticity of supply (PES)

Price elasticity of supply measures how responsive quantity supplied is to price:

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

Common classifications:

• Inelastic supply: less than 1 (sellers are less able to respond)
• Elastic supply: greater than 1
• Unit elastic: equals 1
• Perfectly inelastic: equals 0
• Perfectly elastic: infinite

Supply tends to be more elastic when:

• production is easier to scale up,
• inputs are readily available,
• barriers to entry are low,
• firms can switch to alternatives more easily,
• the time horizon is longer.

In the very short run, supply can be quite inelastic (for example, seats in a stadium for a game tonight). In the long run, supply can become extremely elastic relative to the short run.

Additional production-side cues:

• Characteristics of inelastic supply: difficult production, high costs, hard to change to alternatives, high barriers to entry.
• Characteristics of elastic supply: easy production, low cost, easy to switch to, low barriers to entry.

Exam Focus

• Typical question patterns:
  • Compute elasticity using the midpoint method and classify as elastic/inelastic/unit elastic.
  • Predict the effect of a price change on total revenue using elasticity.
  • Identify substitutes vs. complements using the sign of cross-price elasticity and normal vs. inferior using income elasticity.
  • Explain how time affects elasticity for demand and supply.
• Common mistakes:
  • Forgetting to use percent changes (using raw changes instead).
  • Mixing up “inelastic” with “steep” without context (steep often suggests inelastic, but you still must reason about responsiveness).
  • Getting the sign wrong on cross-price elasticity (substitutes positive, complements negative).

Consumer Surplus, Producer Surplus, Market Efficiency, and Deadweight Loss

Gains from trade: why voluntary exchange creates value

A competitive market tends to create gains from trade: trades happen when buyers value the good more than sellers’ cost of providing it.

On a graph:

• The demand curve reflects buyers’ willingness to pay.
• The supply curve reflects sellers’ marginal cost (the minimum they must receive to supply each unit).

Consumer surplus

Consumer surplus (CS) is what consumers are willing to pay minus what they actually pay.

Graphically, at a market price, CS is the area under demand and above the price line up to the quantity traded. With straight lines, CS is often a triangle:

CS = \frac{1}{2} \times (base) \times (height)

Producer surplus

Producer surplus (PS) is the price producers receive minus the minimum price they would have accepted (marginal cost).

Graphically, PS is the area above supply and below the price line up to the quantity traded. With straight lines, PS is often a triangle:

PS = \frac{1}{2} \times (base) \times (height)

Total surplus and efficiency

Total surplus:

TS = CS + PS

In the basic competitive model (no externalities), equilibrium maximizes total surplus: every unit where willingness to pay exceeds marginal cost is produced, and every unit where marginal cost exceeds willingness to pay is not.

Deadweight loss (DWL)

Deadweight loss (DWL) refers to mutually beneficial transactions that should occur but do not occur because of government intervention (or anything else) that prevents the market from reaching the efficient quantity.

In many common AP graph setups, DWL is a triangle, so you can compute it with:

DWL = \frac{1}{2} \times (base) \times (height)

Worked surplus example (triangles)

Suppose a market demand curve hits the price axis at P = 20, the equilibrium price is P = 10, and equilibrium quantity is Q = 100.

Consumer surplus is a triangle with base 100 and height 10:

CS = \frac{1}{2} \times 100 \times 10 = 500

If the supply curve hits the price axis at P = 0, then producer surplus is:

PS = \frac{1}{2} \times 100 \times 10 = 500

Total surplus is:

TS = 500 + 500 = 1000

Equity vs. efficiency (a common theme)

Many prompts test whether you can separate:

• Efficiency: maximizing total surplus.
• Equity: fairness, affordability, income support, or helping targeted groups.

A policy can improve equity while reducing efficiency; the skill is explaining the trade-off clearly.

Exam Focus

• Typical question patterns:
  • Compute CS, PS, and TS from a graph, often using triangle areas.
  • Identify DWL and compute it as a triangle when appropriate.
  • Explain why equilibrium is allocatively efficient in the basic model.
• Common mistakes:
  • Confusing consumer surplus with total spending (consumer surplus is not P \times Q).
  • Using the wrong triangle height (always compare willingness-to-pay or cost to the market price).
  • Claiming a policy “always helps” one group without noting lost trades and rationing effects.

Government Intervention I: Price Controls (Ceilings and Floors)

Why governments use price controls

A price control is a legal minimum or maximum price. Governments use them for goals that are often about equity (affordability for consumers, income support for producers) rather than pure market efficiency. The trade-off is that binding controls create persistent shortages or surpluses.

Price ceilings

A price ceiling is a legal maximum price.

• If the ceiling is above equilibrium, it is nonbinding (no effect).
• If the ceiling is below equilibrium, it is binding and creates a shortage.

Under a binding ceiling, the low legal price increases quantity demanded and decreases quantity supplied, so:

Q_d > Q_s

Shortages lead to non-price rationing (waiting lines, favoritism, lotteries, “first come first served”).

Example: rent control intuition
If rent is capped below market equilibrium, more people want apartments at the low rent, while fewer landlords supply or maintain apartments. The result is a shortage and often quality deterioration.

Price floors

A price floor is a legal minimum price.

• If the floor is below equilibrium, it is nonbinding.
• If the floor is above equilibrium, it is binding and creates a surplus.

A binding floor causes:

Q_s > Q_d

Common examples:

• Minimum wage (a labor market price floor)
• Some agricultural price supports

Welfare effects: deadweight loss from price controls

Binding price ceilings and floors prevent some mutually beneficial trades that would have occurred at equilibrium, creating deadweight loss.

Price controls also redistribute surplus:

• A ceiling can transfer some consumer surplus to the consumers who manage to buy at the lower price, but it reduces producer surplus and creates inefficiencies.
• A floor can transfer some surplus to producers who manage to sell at the higher price, but it reduces consumer surplus and creates inefficiencies.

Exam Focus

• Typical question patterns:
  • Determine whether a ceiling/floor is binding and predict shortage/surplus.
  • Identify non-price rationing methods under price ceilings.
  • Analyze who gains/loses and whether deadweight loss occurs.
• Common mistakes:
  • Forgetting that nonbinding controls do nothing.
  • Mixing up shortage vs. surplus (ceiling below equilibrium creates shortage; floor above equilibrium creates surplus).
  • Saying a ceiling raises quantity supplied or a floor raises quantity demanded without recognizing the direction of incentives.

Government Intervention II: Taxes and Subsidies

Per-unit (excise) taxes: the wedge idea

A per-unit tax (excise tax) places a fixed tax on each unit bought/sold and creates a wedge between the price buyers pay and the price sellers receive.

If the tax is t per unit:

P_c = P_p + t

• P_c is the price consumers pay.
• P_p is the price producers receive (after the tax).

Taxes typically reduce the equilibrium quantity traded, create deadweight loss, and generate government revenue.

Who pays the tax? (tax incidence)

Tax incidence is how the burden of a tax is split between buyers and sellers.

Key principle: the side of the market that is less elastic bears more of the tax burden.

• If demand is inelastic and supply is elastic, consumers bear most of the tax.
• If demand is elastic and supply is inelastic, producers bear most of the tax.

Legal responsibility for paying the tax is not the same as economic burden.

Graph outcomes of a tax

• A tax on sellers shifts supply upward (or left) by the tax amount.
• A tax on buyers shifts demand downward (or left) by the tax amount.

Either way, the economic outcome is the same:

• consumers pay more than before,
• producers receive less than before,
• quantity falls.

Deadweight loss from a tax

A tax shrinks quantity from the no-tax equilibrium to the after-tax quantity, creating deadweight loss.

In a common linear-curve case:

DWL = \frac{1}{2} \times t \times (Q_{eq} - Q_{tax})

Deadweight loss is larger when demand and supply are more elastic because quantity falls more.

Subsidies: encouraging production or consumption

A subsidy is a per-unit payment that encourages buying or selling.

If producers receive a subsidy of s per unit, then producers effectively receive:

P_p = P_c + s

Subsidies are the mirror image of taxes:

• quantity increases,
• the price consumers pay may fall,
• the price producers receive (including the subsidy) rises,
• and the government pays the subsidy cost.

Subsidies can also create deadweight loss by encouraging production beyond the efficient equilibrium in a simple supply-demand model.

Worked example (basic tax logic without heavy algebra)
Suppose a market is at equilibrium. A per-unit tax is introduced.

• The supply curve shifts upward.
• The new intersection with demand occurs at a smaller quantity.
• Consumers pay a higher price, producers receive a lower price.
• The vertical gap between consumer and producer price is the tax amount.

Exam Focus

• Typical question patterns:
  • Draw and label the effects of a per-unit tax: P_c, P_p, tax revenue, and deadweight loss.
  • Determine which side bears more of the burden using elasticity.
  • Compare the effects of a tax in a more elastic market vs. a more inelastic market.
• Common mistakes:
  • Thinking the side legally taxed necessarily bears the burden.
  • Forgetting that taxes reduce equilibrium quantity.
  • Mislabeling P_c and P_p (consumers pay the higher price; producers receive the lower price).

Other Quantity Controls and Market Rules: Quotas, Licenses, Demand Price, and Supply Price

Quotas (quantity controls)

A quota is an upper limit on the quantity of a good that can be bought or sold (a quantity control). Compared to price controls (which cap or floor the price), quotas directly restrict how much can be exchanged.

Licenses

A license gives an owner the right to supply a good or service. Licenses can limit entry by restricting who is legally allowed to sell, which can affect market supply and the resulting market price.

Demand price and supply price

These terms are useful when interpreting a graph at a specific quantity:

• Demand price: the price at which consumers will demand that quantity (read from the demand curve).
• Supply price: the price at which producers will supply that quantity (read from the supply curve).

These ideas connect naturally to quota analysis, where a fixed quantity can create a wedge between what consumers are willing to pay and what suppliers require.

Exam Focus

• Typical question patterns:
  • Identify a quota as a quantity limit and explain how it can create a wedge between buyers’ willingness to pay and sellers’ required price.
  • Interpret “demand price” and “supply price” from a graph at a given quantity.
  • Explain how licenses can restrict supply by limiting who can sell.
• Common mistakes:
  • Treating a quota as a price ceiling/floor (quotas restrict quantity, not price).
  • Reading “demand price” or “supply price” incorrectly (always read price from the relevant curve at the specified quantity).

International Trade and Public Policy: Tariffs, Import Quotas, and Quota Rent

Tariffs

A tariff is a tax placed on a good that is imported or exported. In AP Micro trade graphs, tariffs typically raise the domestic price of imported goods, reduce the quantity imported, and generate government revenue.

Import quotas

An import quota is a restriction on the quantity of a good that can be imported. Like other quotas, it is a quantity control rather than a direct price control.

Quota rent

Quota rent is the difference between the demand price and the supply price created by a binding quota. It reflects the value (economic benefit) of being allowed to import/sell under the restricted quantity.

Exam Focus

• Typical question patterns:
  • Distinguish tariffs (tax) from import quotas (quantity restriction).
  • Identify quota rent as the gap between demand price and supply price under a binding quota.
• Common mistakes:
  • Confusing quota rent with tax revenue (quota rent accrues to whoever holds the right to sell under the quota, whereas tariff revenue goes to the government).
  • Forgetting that both tariffs and import quotas reduce trade volume relative to free trade.