Supply & Demand

What this unit covers

The topics below follow the published Micro course framework for Unit 2. This unit is worth 20–25% of the exam, so budget your time against that rather than against how long the unit takes to teach.

Lessons in this unit

• Demand, Supply & Market Equilibrium14 min · 3 objectivesDistinguish a change in quantity demanded/supplied from a shift of the curve · Identify the determinants that shift demand and supply · Predict changes in equilibrium price and quantity from shifts
• Elasticity14 min · 3 objectivesCalculate and interpret the price elasticity of demand · Relate elasticity to total revenue · Distinguish price elasticity of supply, income elasticity, and cross-price elasticity
• Surplus, Price Controls & Efficiency14 min · 3 objectivesDefine consumer surplus, producer surplus, and total surplus · Explain how price ceilings and price floors create shortages and surpluses · Analyze the deadweight loss caused by price controls
• Determinants of Demand versus Quantity Demanded14 min · 3 objectivesDistinguish a shift of demand from a movement along the demand curve · Identify the determinants that shift demand and predict the direction · Classify goods as substitutes, complements, normal or inferior from a shift
• Determinants of Supply & the Role of Time13 min · 3 objectivesIdentify the determinants that shift supply and predict the direction · Explain why supply is more elastic in the long run · Distinguish a subsidy from a fall in input costs on the graph
• Elasticity Arithmetic & the Total Revenue Test15 min · 3 objectivesCompute price elasticity of demand using the midpoint method · Classify demand as elastic, inelastic or unit elastic from the coefficient · Use the total revenue test to predict the effect of a price change
• Income & Cross-Price Elasticity13 min · 3 objectivesCompute income elasticity and classify a good from its sign · Compute cross-price elasticity and classify a relationship from its sign · Explain why the sign matters more than the magnitude for these two measures
• Double Shifts & Indeterminate Outcomes14 min · 3 objectivesPredict the effect on price and quantity when both curves shift · Identify which of price and quantity is indeterminate in each double-shift case · Explain what additional information resolves an indeterminate outcome
• Trade, Tariffs & the Cost of Protection14 min · 3 objectivesShow the effect of opening to trade on domestic price, quantity and surplus · Analyze a tariff's effect on consumer surplus, producer surplus, revenue and deadweight loss · Compare a tariff with an equivalent quota

Formulas in Unit 2

Every term in Unit 2

All 57 terms we publish for Supply & Demand, with definitions. Reading them through is the fastest way to find the ones you cannot define — then drill those in cram mode until you can produce them without the prompt.

Price elasticity of demand (PED)

Percentage change in quantity demanded divided by percentage change in price. Report the absolute value; demand is elastic above 1, inelastic below 1.

Total revenue test

If demand is elastic, price and total revenue move in opposite directions. If inelastic, they move together. If unit elastic, total revenue is at its maximum. On a linear demand curve, the upper half is elastic and the lower half inelastic.

Law of demand

Quantity demanded falls as price rises, ceteris paribus. Driven by the substitution effect, the income effect and diminishing marginal utility.

Substitution effect

When a good's price rises, buyers switch toward relatively cheaper alternatives. One of the two reasons demand slopes down.

Income effect

A price rise reduces real purchasing power, so less of the good is bought even with nominal income unchanged.

Change in quantity demanded vs change in demand

A price change moves you along the curve (quantity demanded). Anything else shifts the whole curve (demand). Getting this backward costs points on almost every FRQ.

Demand shifters

Tastes, number of buyers, income, prices of related goods, and expectations. Remember them as TNIPE — and note that the good's own price is not among them.

Normal good

Demand rises when income rises. Most goods.

Inferior good

Demand falls when income rises, because buyers switch to a preferred alternative. Bus travel and instant noodles are the standard examples.

Substitutes

Goods used in place of each other. A price rise for one raises demand for the other, so cross-price elasticity is positive.

Complements

Goods consumed together. A price rise for one lowers demand for the other, so cross-price elasticity is negative.

Law of supply

Quantity supplied rises as price rises, ceteris paribus, because higher prices cover higher marginal costs and attract resources into the market.

Supply shifters

Input prices, technology, number of sellers, taxes and subsidies, and expectations. A change in the good's own price is a movement along the curve.

Market equilibrium

Where quantity demanded equals quantity supplied. The only price with no tendency to change, because there is neither shortage nor surplus.

Shortage

Quantity demanded exceeds quantity supplied, which happens below equilibrium price. Competition among buyers bids the price up.

Surplus

Quantity supplied exceeds quantity demanded, which happens above equilibrium price. Competition among sellers pushes the price down.

Double shift

When both curves move, one of price or quantity is determinate and the other is ambiguous. Say which is ambiguous and why — that is where the point is.

Midpoint method

Percentage changes computed using the average of the two values as the base: ΔQ / [(Q1+Q2)/2] ÷ ΔP / [(P1+P2)/2]. It gives the same answer in either direction.

Determinants of PED

Availability of substitutes, share of income spent, whether the good is a necessity or luxury, and time horizon. Demand is more elastic in the long run.

Perfectly inelastic demand

PED = 0, a vertical demand curve. Quantity does not respond to price at all — the limiting case, and the one where buyers bear the whole tax burden.

Perfectly elastic demand

PED = infinity, a horizontal demand curve. The individual perfectly competitive firm faces exactly this.

Unit elastic demand

PED = 1. Total revenue is at its maximum and does not change with small price changes.

Elasticity along a linear demand curve

Elastic on the upper half, unit elastic at the midpoint, inelastic on the lower half. The slope is constant but elasticity is not — a favorite trap.

Price elasticity of supply (PES)

Percentage change in quantity supplied divided by percentage change in price. Higher when producers can adjust output easily, and always higher in the long run.

Income elasticity of demand

Percentage change in demand divided by percentage change in income. Positive for normal goods, negative for inferior goods, above 1 for luxuries.

Cross-price elasticity of demand

Percentage change in demand for one good divided by percentage change in the price of another. Positive means substitutes, negative means complements, near zero means unrelated.

Consumer surplus

The area below the demand curve and above the price, up to the quantity bought. What buyers were willing to pay minus what they did pay.

Producer surplus

The area above the supply curve and below the price. What sellers received minus the minimum they would have accepted.

Total surplus

Consumer plus producer surplus. Maximized at the competitive equilibrium, which is what makes that equilibrium allocatively efficient.

Deadweight loss

The loss of total surplus when output is not at the efficient quantity. Shown as a triangle between the demand and supply curves over the units not traded.

Price ceiling

A legal maximum price. Binding only if set below equilibrium, where it creates a persistent shortage and deadweight loss. Rent control is the standard example.

Price floor

A legal minimum price. Binding only if set above equilibrium, where it creates a persistent surplus. Minimum wage and agricultural supports are the examples.

Why a non-binding control does nothing

A ceiling above equilibrium or a floor below it never constrains the market, so price, quantity and surplus are unchanged. Check which side of equilibrium the line sits on before analyzing.

Excise tax incidence

The tax burden falls more heavily on whichever side of the market is less elastic, because that side has fewer alternatives. The statutory payer does not determine who bears it.

Effect of a per-unit tax

Supply shifts left by the tax amount. Price to buyers rises, price received by sellers falls, quantity falls, and the difference between the two prices is the tax.

Subsidy

A per-unit payment to producers. Supply shifts right, quantity rises above the efficient level, and the result is deadweight loss even though both sides appear better off.

Tax revenue on a graph

The rectangle whose height is the tax per unit and whose width is the after-tax quantity. The deadweight-loss triangle sits beside it, over the units no longer traded.

Shift vs movement, in one test

Own price changes → movement along the curve. Anything else → the curve shifts. Half the multiple choice in this unit tests nothing else.

The five demand shifters

Tastes, prices of related goods, income, number of buyers, expectations. Own price is NOT one — it is the vertical axis.

Substitutes vs complements

Substitutes: a higher price for one RAISES demand for the other. Complements: a higher price for one LOWERS it. The direction identifies the relationship.

Normal vs inferior

Rising income raises demand for a normal good and LOWERS it for an inferior one. So a recession raises demand for inferior goods.

The supply shifters

Input prices, technology, taxes and subsidies, number of sellers, expectations, and weather for agriculture.

Why supply is more elastic in the long run

Firms can expand capacity and new firms can enter. In the very short run the plant is fixed and supply is close to inelastic.

A per-unit tax as a vertical shift

Supply shifts up by exactly the tax, so the vertical gap between the two curves IS the tax. This is how you read the tax off a graph.

Who bears a tax

The more inelastic side of the market. With inelastic demand consumers absorb most of it; with inelastic supply producers do.

The midpoint method

E = [ΔQ ÷ average Q] / [ΔP ÷ average P]. Dividing by averages makes the answer the same in either direction; using starting values does not.

The total revenue test

Elastic: raising price LOWERS revenue. Inelastic: raising price RAISES it. Unit elastic: revenue is maximized and unchanged.

Four determinants of elasticity

Substitutes available, share of budget, necessity versus luxury, and time horizon. All four make demand more elastic when present.

Elasticity varies along a straight line

Elastic at high prices and low quantities, inelastic at low prices, unit elastic at the midpoint. Slope and elasticity are not the same thing.

Sign matters for income and cross-price

Income: positive = normal, negative = inferior. Cross-price: positive = substitutes, negative = complements. Taking absolute values throws away the answer.

Necessity vs luxury

Income elasticity between 0 and 1 is a necessity; above 1 is a luxury. Which is why recessions hit luxury sectors hardest.

Double shift: same direction

Both curves shifting the same way determines QUANTITY and leaves price indeterminate.

Double shift: opposite directions

Curves shifting opposite ways determine PRICE and leave quantity indeterminate. Find the variable both arrows agree about.

When indeterminate becomes determinate

Magnitude language — "supply rose substantially while demand rose slightly" — resolves the ambiguity. Read for it before answering "indeterminate".

Gains from opening to trade

Consumer surplus rises by more than producer surplus falls when the world price is below the domestic one, so total surplus rises.

The two tariff deadweight triangles

The production distortion (inefficiently high-cost domestic output) and the consumption distortion (forgone consumption). Neither is captured by anyone.

Quota versus tariff

Same price effect and same two triangles. The rectangle a tariff collects as revenue becomes quota rents for license holders instead.

What examiners penalize here

• For a **double shift**, one variable is always determinate and the other ambiguous. Identify the shared direction (both shifts pushing price *or* quantity the same way) — that variable is certain; the other depends on relative shift sizes.
• For cross-price and income elasticities, read the **sign** first: cross-price positive = substitutes, negative = complements; income positive = normal, negative = inferior. Magnitude tells you *how strong*, but the sign tells you *what kind*.
• On price-control graphs, show the **reduced quantity traded**, then mark the **deadweight-loss triangle** between the supply and demand curves at that quantity. Distinguish the **transfer** of surplus between groups from the **deadweight loss** that no one captures — the exam tests both.
• On any supply-and-demand free response, name the determinant explicitly — "the price of the substitute rose, so demand shifts right" — rather than just drawing the arrow. The named determinant is usually its own point.
• When a graph question involves a tax, label three prices: what consumers pay, what producers receive, and the original equilibrium. The gap between the first two is the tax, and tax incidence is read from how the original price sits between them.
• Use the midpoint method unless the question explicitly says otherwise, and show the two averages. Rubrics award the setup separately from the value, so a visible ΔQ/average-Q calculation earns credit even if the division slips.
• State the sign and the classification together — "−0.25, so the good is inferior". Rubrics typically award the coefficient and the interpretation as separate points, and the interpretation is the one students omit.
• Draw both shifts and then check each variable separately: do the two arrows agree about price? About quantity? The one they agree about is determined, the other is not. This is faster and safer than recalling four memorized cases.
• Label the world price line, the tariffed price line, and the four domestic quantities before computing any area. Trade-graph questions are almost entirely about reading areas correctly, and an unlabeled diagram makes that impossible to do reliably.

Practice Micro

Our practice bank is drawn from across the whole course rather than filtered to one unit, which is closer to how the exam asks anyway — it will not tell you which unit a question is testing.

Questions about this unit

All 6 units of AP Microeconomics

1. Unit 1 · Basic Economic Concepts
2. Unit 2 · Supply & Demand
3. Unit 3 · Production, Cost & Perfect Competition
4. Unit 4 · Imperfect Competition
5. Unit 5 · Factor Markets
6. Unit 6 · Market Failure & Government