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Credit Sprint's Guide to Microeconomics Unit 2: Supply and Demand

AP® weight 20–25%CLEP® weight 20–30%

Supply and demand set prices in competitive markets. Elasticity measures how strongly buyers and sellers respond to price, consumer and producer surplus measure the gains from trade, and government interventions like price controls, taxes and tariffs change those gains and create deadweight loss.

What you need to know

  • A change in the good's own price moves along the curve. Anything else (income, tastes, related prices, expectations, number of buyers or sellers, input costs, technology) shifts it.
  • Substitutes: the price of one rises, demand for the other rises. Complements: the price of one rises, demand for the other falls.
  • Normal goods: demand rises with income. Inferior goods: demand falls as income rises.
  • When supply and demand both shift, either price or quantity is indeterminate unless you know the sizes of the shifts.
  • Price elasticity of demand > 1 is elastic, < 1 inelastic. Close substitutes, luxuries, a big share of income and more time all make demand more elastic.
  • Total revenue test: if price and total revenue move in opposite directions, demand is elastic; same direction, inelastic; TR unchanged, unit elastic.
  • Consumer surplus is the area below demand and above price; producer surplus is above supply and below price.
  • A binding price ceiling (below equilibrium) causes a shortage; a binding price floor (above equilibrium) causes a surplus. Both create deadweight loss.
  • An excise tax shifts supply up by the tax. The more inelastic side of the market bears more of the tax.
  • A tariff raises the domestic price, increases domestic production, reduces imports and creates deadweight loss.

Formulas

Price elasticity of demand = %ΔQd ÷ %ΔP (use absolute value)
Midpoint % change = (new − old) ÷ ((new + old) ÷ 2)
Income elasticity = %ΔQd ÷ %ΔIncome (negative = inferior good)
Cross-price elasticity = %ΔQd of X ÷ %ΔP of Y (positive = substitutes, negative = complements)
Total revenue = P × Q
Area of a triangle (surplus, DWL) = ½ × base × height
Tax revenue = tax per unit × quantity sold after the tax

Exam traps

Watch for"Change in demand" (shift) is not "change in quantity demanded" (movement along).
Watch forA price ceiling ABOVE equilibrium, or a floor BELOW it, is non-binding and does nothing.
Watch forElasticity is not slope. Along a straight-line demand curve, elasticity changes: the top half is elastic, the bottom half inelastic.
Watch forWho writes the tax check (buyer or seller) doesn't decide who bears it. Relative elasticity does.

Key terms

  • Law of demand: Other things equal, as price rises, quantity demanded falls.
  • Substitutes: Goods used in place of each other. A higher price for one raises demand for the other.
  • Complements: Goods used together. A higher price for one lowers demand for the other.
  • Normal good: A good whose demand rises when income rises.
  • Inferior good: A good whose demand falls when income rises.
  • Equilibrium: The price where quantity demanded equals quantity supplied, so there is no shortage or surplus.
  • Price elasticity of demand: How responsive quantity demanded is to a change in price: %ΔQd ÷ %ΔP.
  • Perfectly inelastic: Quantity doesn't respond to price at all. A vertical curve; elasticity = 0.
  • Total revenue test: If P and TR move in opposite directions, demand is elastic; the same direction, inelastic.
  • Consumer surplus: Buyers' gain: the difference between what they're willing to pay and what they pay. Area under demand, above price.
  • Producer surplus: Sellers' gain: price received minus the minimum they'd accept. Area above supply, below price.
  • Deadweight loss: Total surplus lost when output is not at the efficient quantity.
  • Price ceiling: A legal maximum price. Binding when set below equilibrium; causes a shortage.
  • Price floor: A legal minimum price. Binding when set above equilibrium; causes a surplus.
  • Tax incidence: How the burden of a tax is split between buyers and sellers. The more inelastic side pays more.
  • Tariff: A tax on imports. Raises the domestic price and domestic production, reduces imports and consumption.

Practice questions

Five of the 53 Unit 2 questions in Credit Sprint. Every choice is explained in the app.

1. The law of demand states that, other things equal,
  1. as income rises, quantity demanded rises
  2. as price rises, quantity demanded falls
  3. as price rises, demand falls
  4. as price rises, quantity supplied rises
  5. as demand rises, price falls
Show answer

as price rises, quantity demanded falls. Price and quantity demanded move in opposite directions.

2. At a price above the equilibrium price, there will be
  1. a surplus, which pushes the price down
  2. an increase in demand
  3. equilibrium
  4. a shortage, which pushes the price up
  5. a surplus, which pushes the price up
Show answer

a surplus, which pushes the price down. Quantity supplied exceeds quantity demanded.

3. Total revenue is maximized on a straight-line demand curve where demand is
  1. perfectly elastic
  2. unit elastic
  3. perfectly inelastic
  4. highly elastic
  5. highly inelastic
Show answer

unit elastic. At that point a small price change doesn't change revenue.

4. A $2 per-unit tax is placed on sellers of a good. The supply curve will
  1. not move; the demand curve shifts down
  2. shift up (left) by $2 at every quantity
  3. become vertical
  4. shift down (right) by $2
  5. shift up by more than $2
Show answer

shift up (left) by $2 at every quantity. Sellers need $2 more to supply each unit.

5. An import quota differs from a tariff mainly because a quota
  1. benefits domestic consumers
  2. limits the quantity of imports directly and raises no tax revenue
  3. increases imports
  4. has no deadweight loss
  5. lowers the domestic price
Show answer

limits the quantity of imports directly and raises no tax revenue. Quotas restrict quantity; tariffs collect revenue.