Demand, Supply & Equilibrium

Economics & Law - NIT Northern Institute of Technology / TUHH, Hamburg · part of my Technology Management MBA · study notes for revision.

Chapter 1 installed the mindset: people make choices under scarcity, and law works by changing the costs and benefits of those choices. Now we build the machine that turns all those individual choices into two visible numbers - the market price and the quantity actually traded.

The plan is simple. Demand is the buyers’ side (how much they’ll take at each price). Supply is the sellers’ side (how much they’ll make at each price). Push the two together and you get an equilibrium - the one price where the amount people want to buy exactly matches the amount firms want to sell.

1 · Demand: willingness to pay

Start with a single buyer. The cleanest way to measure how much a person values something is their willingness to pay (WTP) - the largest amount of money they would hand over for the product rather than go without it. If John would happily pay 5 euros for a shirt and would still agree at 6, then his WTP is the top number, 6 - the most he’d part with.

What sets a person’s WTP? Three things: their tastes, their income, and crucially the other products around them. That last one is worth naming carefully, because two kinds of “other product” pull in opposite directions:

Type	Meaning	Everyday example
Substitutes	Goods that fill a similar need - you’d swap one for the other	Pepsi and Coke; train and bus
Complements	Goods that are used together, so one raises the value of the other	Computer and keyboard; printer and ink

The interesting bit is how a price change in one good moves demand for another:

Price of Coke risesa substitute for Pepsi

→

Demand for Pepsi risesbuyers switch across

Price of keyboards risesa complement to PCs

→

Demand for PCs fallsthe bundle got pricier

Substitutes move demand the same way as the other good’s price (Coke dearer → I want Pepsi instead). Complements move it the opposite way (dearer keyboards → I want fewer computers).

2 · The demand curve and the law of demand

Now ask one buyer a whole menu of questions: how many cups of coffee would you buy per day at 1 euro? at 2? at 3? Plot the answers with price on the vertical axis and quantity on the horizontal axis, and you get that buyer’s demand curve - a picture of WTP for each successive unit.

Two features show up every time. First, the curve slopes downward: the lower the price, the more units people want. This is famous enough to have a name.

Second, to talk about a whole market rather than one person, you add up every individual’s demand at each price. That gives the total (market) demand curve: the quantity all buyers together want at any given price. It still slopes down, for the same reason. (One quiet assumption throughout: we’re treating the units as homogeneous - every cup of coffee is the same cup - so buyers only care about price.)

Slides along vs shifts of the curve

This distinction trips people up, so pin it down. Picture the market for copies of a CD.

Slide move ALONG the curve

Caused by a change in the good’s own price
Price drops → you move down-and-right to a bigger quantity
The curve itself doesn’t move - you just relocate on it
This is “a change in quantity demanded”

Shift the WHOLE curve moves

Caused by a shock - something other than the price
Shifts: income, advertising, technology, price of substitutes/complements
Up/right = more wanted at every price (e.g. good advertising lifts WTP)
Down/left = less wanted at every price (e.g. online shopping kills CD demand)

The rule of thumb: the good’s own price → a slide; anything else → a shift. Advertising raises WTP at every price, so the entire curve lifts; a sudden discount just walks you down the curve you already had.

3 · Elasticity of demand

“Demand slopes down” tells us the direction of the response. Elasticity tells us the size of it - how strongly quantity reacts when price moves. It’s one of the most-used numbers in the whole course.

Price elasticity of demandEd = (% change in quantity) / (% change in price)

Point formEd = (p / q) × (Δq / Δp)

Δ (delta) “the change in” - so Δq is new quantity minus old quantity

Why is it always negative? Because of the law of demand: push price up and quantity goes down, so one of the two percentage changes is negative and the ratio comes out below zero. Many textbooks quietly drop the minus sign and talk about the absolute value - just know the “true” number is negative.

Point vs arc. There are two flavours of the same idea:

Point elasticity measures the reaction at one specific point on the curve (it uses the starting price and quantity).
Arc elasticity measures it between two points, using the midpoint (the average price and average quantity) as the base. It’s a bit more even-handed when the two points are far apart.

Worked example - walking down a demand curve

Take three points on a demand curve. Every step here is a 10-euro price rise that loses 200 units of sales (Δq = −200, Δp = 10):

Point	Price	Quantity
A	60	3000
B	70	2800
C	80	2600

Point elasticity, A → B: (p/q) × (Δq/Δp) = (60/3000) × (−200/10) = 0.02 × (−20) = −0.4

Point elasticity, B → C: (70/2800) × (−200/10) = 0.025 × (−20) = −0.5

Notice the elasticity changed even though the curve is a straight line - that’s the key lesson: elasticity is not the same as slope, and it drifts as you move along the curve.

Now the arc versions, using midpoints (average price, average quantity):

Arc, A → B: (65/2900) × (−200/10) = −0.448

Arc, B → C: (75/2700) × (−200/10) = −0.556

The arc numbers sit close to the point numbers but smooth out the difference between the two ends.

Reading the number

The absolute value is what tells the story - compare it to 1:

Inelasticbetween 0 and 1

Unit-elasticexactly 1

Elasticgreater than 1

Elastic (above 1): the quantity change out-runs the price change - a small price cut wins a lot of extra sales. Inelastic (0 to 1): quantity barely budges. Unit-elastic (1): the two percentage moves match.

At the two extremes:

Perfectly elastic (a flat, horizontal demand curve): the tiniest price rise loses all your customers. This is what a small firm in perfect competition faces.
Perfectly inelastic (a vertical demand curve): buyers want a fixed quantity no matter the price.

What makes demand elastic?

Two big drivers:

Driver	Elastic (sensitive) when…	Inelastic (stuck) when…
Close substitutes	Easy swaps exist (Pepsi ↔ Coke) - a small price rise sends me elsewhere	No real alternative exists
Luxury vs necessity	It’s a luxury (a 5-star hotel - I’ll just skip the trip)	It’s a necessity (life-saving antibiotics - I’ll pay whatever it costs)

Two cousins worth naming

The same “percent-over-percent” idea gives two other useful elasticities:

Cross-price elasticity = % change in quantity of X ÷ % change in the price of another product Y. If it’s positive, X and Y are substitutes; if negative, they’re complements. (It literally measures the substitute/complement relationship from section 1.)
Income elasticity = % change in quantity ÷ % change in income. Positive for normal/luxury goods (richer, so I buy more), negative for inferior goods (richer, so I buy less - think instant noodles), around zero for “sticky” staples like salt.

4 · Total revenue and marginal revenue

Elasticity isn’t just theory - it decides whether cutting your price makes or loses money. That’s the puzzle behind the real 1930s Cola wars: a near-bankrupt Pepsi started selling a 12-ounce bottle for 5 cents (the price of a 6-ounce Coke), and sales exploded. Why was dropping the price so profitable? Revenue is how we answer.

Total revenueTR = Price × Quantity sold

Marginal revenueMR = the change in TR from selling one MORE unit

Total revenue (TR) typically traces an inverse-U shape as you sell more. Here’s the link to elasticity: to sell more units you have to lower the price, and whether TR rises or falls depends on which effect wins.

While demand is elastic, the extra units more than make up for the lower price → TR rises. (Pepsi’s move lived here.)
Once demand turns inelastic, the price cut no longer pulls in enough new buyers → TR falls.
The peak of the inverse-U sits exactly where demand is unit-elastic. That answers a summary question: if Apple sells 1M iPhones and demand is unit-elastic there, should it produce more? No - it’s already at the top of the TR hill.

Marginal revenue (MR) zooms in on one extra unit: how much did total revenue change when I sold that one more? It’s positive while TR is climbing and negative once TR starts falling. The subtle part is that MR depends on what kind of market you’re in:

Perfect competition a price taker

The firm is tiny; it can’t move the market price
Every extra unit sells at the same price P
So MR = P - a flat horizontal line

Monopoly a price setter

The firm controls the price
To sell more it must drop the price - and not just on the last unit, on all units
So MR sits below the demand curve

Why a monopoly’s MR is below its price

This “cut the price for everyone” effect is the whole reason monopoly behaves differently. Walk it through with the classic little table:

Price (P)	Quantity (Q)	TR = P × Q	MR = ΔTR
10	1	10	10 − 0 = 10
9	2	18	18 − 10 = 8
8	3	24	24 − 18 = 6

Selling the 2nd unit needs the price to fall from 10 to 9 - but the monopolist now charges 9 on the first unit too. So the true gain from unit two isn’t 9; it’s 9 × 2 − 10 × 1 = 18 − 10 = 8. That 8 is the MR, and it’s below the 9 that the demand curve shows. That gap (MR under the demand price) is the seed of everything about monopoly.

5 · Supply: the costs behind it

Flip to the seller. A firm’s willingness to produce is driven by its costs, so we need a quick cost vocabulary.

Total costeverything

Fixed costsame at any output

Variable costgrows with output

Total cost splits in two. Fixed costs are paid even if the firm makes zero (rent on a machine, a factory). Variable costs rise with each unit made (materials, overtime).

Fixed costs don’t depend on how much you make - you pay them even at zero output, and you can’t change them in the short run (a 10-year machine lease, the money already sunk into building the Elbphilharmonie). When a fixed cost is already spent and unrecoverable, it’s a sunk cost - and a key rule is that sunk costs should be ignored in forward-looking decisions.
Variable costs rise with output - more bottles means more syrup.
Opportunity cost hides inside both. If Apple has 1M euros it could either bank at 8% interest or spend on metal to make 1000 more units, then the true cost of the metal is the cash paid plus the 8% interest given up. Every cost is really “the best thing you gave up.”

Marginal cost - usually rising

Marginal cost (MC) is the extra cost of making one more unit (variable costs are just the sum of all the marginal costs). The MC curve normally slopes upward - each extra unit costs a bit more than the last. Why?

You use your best, most specialised workers first; expanding means pulling in less-suited ones.
At some point you’re paying overtime, which is dear.

(It can dip in places - economies of scale can make an extra unit cheaper for a while - but those cheap-expansion windows usually don’t last.)

Average cost - U-shaped

Average cost (AC) is total cost divided by the number of units:

Average costAC = (Fixed costs + Variable costs) / Number of units

The AC curve is U-shaped, and you can feel why by pulling on its two halves. At low output, the fixed cost is spread over very few units, so average fixed cost is huge - AC starts high and falls fast as you spread it thinner. But keep expanding and the rising marginal cost eventually takes over and drags the average back up. High-then-low fixed share, low-then-high marginal cost: the two forces cross, giving the U.

Worked example - how much to produce

A firm faces these costs. Fill in total variable cost (AVC × Q) and marginal cost (the jump in total variable cost), then decide output if the product sells for 36 euros:

Quantity	Avg. variable cost	Total variable cost	Marginal cost
1	10	10	10
2	15	30	20
3	20	60	30
4	25	100	40
5	30	150	50

Apply the rule from section 4 - keep going while each unit’s MC is below the price. At Q = 3 the MC is 30 (still under 36, worth making); at Q = 4 the MC jumps to 40 (above 36, a loss-maker). So the firm produces 3 units - the last unit where MC is still below price.

6 · Scarcity, the PPF and the supply curve

Step back from one firm to the whole economy’s production problem. Scarcity is the gap between what people want and what the available resources allow. It bites for anything limited (unlike air, which is free) - and it forces a trade-off: making more of one good means making less of another.

The production-possibility frontier

Imagine an economy that can only make two things - the classic “guns and butter.” The production-possibility frontier (PPF) is the curve of every efficient combination it could produce with full employment (no wasted workers) and workers put to their best use.

On the frontierefficient - no waste

↑ can’t reach

Point A: inside the curveachievable but wasteful

↑

Point X: outside the curveunattainable with today’s resources

Points on the frontier are efficient. A point inside (A) is achievable but wastes resources. A point outside (X) simply can’t be reached with the resources you have.

The PPF is concave (bowed outward). Starting from all-butter, the first guns are cheap - you shift over the workers who are bad at butter anyway, giving up very little butter. Keep going and each extra gun costs more and more butter, because now you’re pulling over your butter specialists. That’s increasing opportunity cost, and it’s the same rising-MC story from section 5, told at the level of the whole economy.

A quick taste of comparative advantage

The concave shape comes from workers differing. Suppose two workers can each make guns or butter:

Worker	Butter	Guns
A	2	4
B	1	1

Worker A is better at both - an absolute advantage. So should A do everything? No. The right question is opportunity cost - what each worker gives up:

Worker	Cost of 1 butter (in guns)	Cost of 1 gun (in butter)
A	2 guns	0.5 butter
B	1 gun	1 butter

Worker A gives up only 0.5 butter per gun (cheaper at guns); Worker B gives up only 1 gun per butter (cheaper at butter). So put A on guns, B on butter - each on the good where their opportunity cost is lowest. That’s comparative advantage, and it’s why even a less-productive worker (or country) is still worth trading with. We give it the full treatment in the international-trade chapter.

From costs to the supply curve

All of this feeds one line. A firm’s willingness to produce depends on its marginal cost, so:

7 · Equilibrium: where supply meets demand

Now put the two curves in one diagram. Equilibrium is the price where quantity demanded = quantity supplied - the market “clears,” with no leftover buyers or sellers. Algebraically, you just set the two quantities equal.

Worked example - solving for price and quantity

The market for coffee has:

DemandQd = 600 − 2p

SupplyQs = 300 + 4p

Set supply equal to demand (that’s what equilibrium means): 600 − 2p = 300 + 4p
Solve for the price. Gather the p terms: 600 − 300 = 4p + 2p, so 300 = 6p, giving p = 50.
Plug back in to get the quantity. Using supply: Q = 300 + 4 × 50 = 500. (Check with demand: 600 − 2 × 50 = 500. ✓)

So the market settles at a price of 50 and a quantity of 500. That’s the whole point of the machine: two curves in, one price and one quantity out.

What if the price is “wrong”?

The market self-corrects toward equilibrium:

Situation	What it means	The market’s response
Excess supply (S greater than D)	Price too high - sellers offer more than buyers want	Unsold stock piles up → price falls, some firms cut output or exit
Excess demand (D greater than S)	Price too low - buyers want more than sellers offer	Shortages appear → price rises, production and entry are encouraged

Either way, the gap shrinks and the market drifts back to the crossing point.

The long run: entry and exit

There’s a slower adjustment on top of that. Suppose the price sits at 400 and, at the quantity firms are making, P = MC = 400 but AC is lower - so P is greater than AC. Each firm is earning an economic profit. That’s a magnet: new firms enter (and existing ones expand) to grab it. More firms means more supply, which pushes the price down. This keeps going until the profit is competed away.

8 · Market power: monopoly vs perfect competition

The last piece explains why the price you get depends on the shape of the market. A firm has market power when it can raise its price without losing all its customers to a rival. The two textbook extremes are perfect competition (zero market power) and monopoly (maximum market power).

Perfect competitionno power - price taker

↔ spectrum

Monopolyfull power - price setter

Real markets sit somewhere between these two poles. What moves a firm toward the monopoly end is anything that stops customers switching away - brands, information gaps, patents.

Perfect competition is a demanding checklist. All of these must hold:

many buyers & sellersa homogeneous productno information asymmetry on priceno transaction costsfree entry & exit

When they all hold, no single firm can nudge the price - each faces perfectly elastic demand (try to charge a cent more and every customer walks). That’s the world where MR = P and, in the long run, profits are competed down to zero.

Market power comes from breaking that list - usually through information asymmetries (customers can’t tell products apart) or product differentiation (a brand people specifically want). And here’s the clean link to section 3: market power is really just low elasticity. If customers won’t switch away when you raise the price - a patented, life-saving drug is the extreme case - your demand is inelastic, and that is your power to price above cost.

Why a monopoly produces less and charges more

Both a competitive firm and a monopolist obey the same profit rule, MR = MC. The difference is where MR sits:

Perfect competition

MR = P (the demand line itself)
Sets MC = P → produces the larger quantity q_c
Charges the lower, competitive price

Monopoly

MR is below the demand curve (section 4)
MC = MR is reached sooner → smaller quantity q_m
Reads the price for that smaller q off the (higher) demand curve

Because the monopolist’s MR line sits under the demand curve, its MR = MC point lands at a smaller quantity than a competitive market would produce. Then it charges whatever the demand curve says buyers will pay for that smaller quantity - a higher price. So the monopoly’s signature is: less output, higher price. Exactly how bad that is for society - the efficiency cost of it - is the story of the next chapter.

Revision summary

The one-minute recap

Demand rests on willingness to pay (the most a buyer would pay). Substitutes move demand the same way as the other good’s price; complements move it the opposite way.
The demand curve slopes down (law of demand). A change in the good’s own price is a slide along it; any other shock (income, ads, tech, related prices) shifts the whole curve.
Elasticity = %ΔQ / %ΔP, always negative. Elastic (absolute value above 1) = sensitive; inelastic (0 to 1) = stuck; unit-elastic = 1. Fixed spending → unit-elastic; fixed quantity → perfectly inelastic. Close substitutes and luxuries make demand elastic.
TR = P × Q (inverse-U), and it rises only while demand is elastic. MR is the revenue from one more unit: MR = P in perfect competition, but below the demand curve for a monopoly (it must cut price on all units). Firms produce until MR = MC.
Supply comes from costs: fixed vs variable (with sunk and opportunity costs inside), rising marginal cost, and a U-shaped average cost. The PPF shows scarcity and increasing opportunity cost (why it’s concave); comparative advantage says assign each worker to their lower-opportunity-cost good. Result: an upward-sloping supply curve.
Equilibrium is where supply = demand (solve Qd = Qs → p, then Q). Excess supply/demand self-corrects on price; in the long run, entry and exit drive P = MC = AC.
Market power = ability to raise price without losing everyone, which is just low elasticity. Perfect competition needs many traders, a homogeneous product, no info gaps, no transaction costs, and free entry/exit. A monopoly, with MR below demand, hits MR = MC sooner → less output, higher price.

Next: Efficiency & Welfare → - measuring what a market is actually worth.