Chapter 2 — Demand, Supply, Equilibrium, and Welfare

Core question

How do the plans of many buyers and sellers determine a price, quantity, and allocation?

Learning outcomes

You will be able to:

• distinguish a movement along a curve from a shift;
• solve equilibrium graphically and algebraically;
• explain shortage, surplus, and price adjustment;
• use consumer and producer surplus to evaluate a market outcome.

1. Demand is a schedule

Demand records the quantity buyers are willing and able to purchase at each possible price during a stated period, holding other determinants fixed.

where income Y, related-good prices P_r, tastes T, expectations E, and number of buyers N are held fixed along one curve.

The law of demand is conditional, not a claim that sales can only change because price changed.

2. Supply is also a schedule

Supply records the quantity sellers are willing and able to offer at each price, holding technology, input costs, expectations, policy, and seller numbers fixed.

3. Solve the campus coffee market

Suppose hourly plans are:

At equilibrium, planned purchases equal planned sales:

At P = £2, buyers want 80 cups and sellers offer 40: shortage = 40. At P = £6, sellers offer 80 and buyers want 40: surplus = 40.

Equilibrium means no internal pressure for price to change under the model. It does not imply fairness, perfect information, or social optimality.

Predict before changing a coefficient.

4. Comparative statics

Use five steps:

1. name the market and time horizon;
2. identify the changed determinant;
3. move the correct curve;
4. compare old and new equilibria;
5. state what is ambiguous or held fixed.

Milk-cost shock

Suppose higher milk costs change supply to:

Then:

Price rises and quantity falls. The result is a model prediction conditional on demand not shifting at the same time.

Two simultaneous shifts

If demand rises and supply falls, price rises but quantity is ambiguous. Never invent the ambiguous sign; explain what relative shift sizes would determine it.

5. Surplus gives equilibrium a welfare interpretation

Consumer surplus is willingness to pay minus price. Producer surplus is price minus minimum willingness to accept, closely related to variable cost.

Example:

If a seller's minimum acceptable price for those units is £2 and £3, producer surplus is £2 and £1. Total surplus from the two trades is £7.

Under competitive assumptions and no market failures, equilibrium trades exhaust gains from exchange. Chapter 4 shows why those assumptions sometimes fail.

6. Price controls change allocation, not only price

Binding ceiling

Set coffee's legal maximum price at £3:

The legal price is lower, but not every buyer obtains coffee. Allocation may occur through queues, waiting time, favouritism, quality reduction, or resale.

Binding floor

A minimum price above equilibrium creates excess supply unless another policy purchases or removes it.

Policy evaluation must therefore track:

legal price → quantities planned → rationing/stock → quality and entry → distribution

7. What the model leaves out

The basic market diagram may omit:

• market power and strategic pricing;
• search, matching, and transaction costs;
• unequal information;
• spillovers on non-participants;
• adjustment time and capacity constraints;
• fairness of the initial distribution of income and rights.

Omission does not make the model useless. It defines the boundary of the answer.

Practice

A city gains 10,000 students while a construction-cost shock affects rentals.

1. Draw the initial market.
2. Shift demand and supply separately.
3. State the unambiguous price result.
4. Explain why the quantity result is ambiguous.
5. Add a rent ceiling and identify both the beneficiary and the rationing mechanism.
6. Name evidence needed to estimate the size of each shift.

Quick check

• Own-price change: movement along the curve.
• Other determinant: shift of the curve.
• Shortage and surplus are defined at a particular price.
• Equilibrium is not automatically equitable or efficient.
• With two shifts, one outcome may be indeterminate.

Next: measure responsiveness and analyse revenue and tax incidence.