Demand, Supply and Market Equilibrium: Revision Notes

Condensed for the final weeks, covering the SL-level content of sub-topics 2.1-2.3. For the full syllabus, including HL-only extensions, use the IB DP Economics syllabus guide. These three sub-topics open Unit 2 – Microeconomics, and they build directly on the scarcity-and-opportunity-cost toolkit introduced in Unit 1.

Demand (2.1)

• The law of demand: as price rises, quantity demanded falls, ceteris paribus (all else equal). This inverse relationship is what gives the demand curve its characteristic downward slope on a price-quantity diagram.
• A change in price causes a movement along the demand curve; a change in any other determinant (income, tastes, price of substitutes/complements, population, expectations) causes a shift of the whole curve.
• Always distinguish “change in demand” (shift) from “change in quantity demanded” (movement). Use this precise vocabulary rather than the vaguer phrase “demand changes” for both situations.

Supply (2.2)

• The law of supply: as price rises, quantity supplied rises, ceteris paribus, since a higher price makes it more profitable for firms to supply more. (The Higher Level justification for this — that marginal cost rises through diminishing marginal returns, so firms need a higher price to cover the cost of extra units — is not Standard Level content.)
• A change in price → movement along the supply curve. A change in a non-price determinant (costs of production, technology, number of firms, taxes/subsidies, expectations, and the prices of related goods in joint or competitive supply) → shift.

Competitive market equilibrium (2.3)

Price
  ^
  | D                 S
  |  \               /
  |   \             /
  |    \           /
  |     \         /
  |      \       /
  |       \     /
  |        \   /
  |         \ /
Pe|----------X
  |         /:\
  |        / : \
  |       /  :  \
  +---------------------------> Quantity
             Qe

The downward-sloping line is demand (D); the upward-sloping line is supply (S); the vertical axis is Price and the horizontal axis is Quantity; the two lines cross at X, where the dashed line across to the price axis marks the equilibrium price (Pe) and the dotted line down to the quantity axis marks the equilibrium quantity (Qe) directly beneath the intersection.

Equilibrium is where quantity demanded = quantity supplied. A shortage (price below equilibrium) pushes price up; a surplus (price above equilibrium) pushes price down — markets self-correct toward equilibrium in a competitive market, absent intervention.

Consumer surplus, producer surplus and allocative efficiency (2.3)

• Consumer surplus is the difference between what consumers are willing and able to pay and what they actually pay — the area below the demand curve and above the market price.
• Producer surplus is the difference between what producers actually receive and the minimum they would have accepted — the area above the supply curve and below the market price.
• Social (or community) surplus is the sum of the two, and is at its maximum at the competitive market equilibrium, where the demand and supply curves intersect.
• At that equilibrium, marginal benefit equals marginal cost: the value society places on the last unit consumed equals the cost of producing it, so resources are allocated where they create the most value — this is allocative efficiency. Producing at any other quantity, more or less, reduces total surplus.

The functions of the price mechanism

Once equilibrium is established, the price mechanism performs three linked functions worth naming explicitly in an evaluative answer:

• Signalling — price changes tell producers and consumers something has changed in the market (e.g. a price rise signals rising demand or falling supply).
• Incentive — a higher price incentivises producers to supply more and consumers to demand less, and vice versa for a lower price.
• Rationing — price rations scarce goods to those most willing and able to pay, without any central authority allocating output directly.

These three functions work together automatically in a competitive market — no single participant plans them — which is precisely the feature evaluative essay questions often ask you to assess against alternative allocation mechanisms, such as government-planned allocation.

How a shift changes equilibrium

When a determinant other than price changes, the whole curve shifts and a new equilibrium is established at the point where the new curve intersects the other (unchanged) curve:

• A rightward (outward) shift of demand, with supply unchanged, raises both equilibrium price and equilibrium quantity.
• A rightward shift of supply, with demand unchanged, lowers equilibrium price but raises equilibrium quantity.
• If both curves shift simultaneously, the direction of the change in price or quantity can become ambiguous without more specific information — a common higher-mark question tests exactly this ambiguity.

A first look at price ceilings

A price ceiling is a maximum legal price set by the government, and only has an effect on the market if it is set below the free-market equilibrium price. At that lower price, quantity supplied falls below quantity demanded, creating a shortage: the quantity of the good actually available to buyers falls short of what the free-market equilibrium quantity would have been, even though the ceiling was intended to make the good more affordable. Price ceilings on housing rents are the standard example. This is only a preview of price controls — the full sub-topic on government intervention in markets, covering both price ceilings and price floors in depth, is part of sub-topic 2.7, Role of government in microeconomics, which is not covered by these notes.

Connecting forward to elasticity

Sub-topics 2.1-2.3 (demand, supply, equilibrium) set up the diagrams that Unit 2’s later sub-topics on elasticity (2.5, 2.6) build directly on top of. Elasticity asks how much quantity demanded or supplied responds to a change in price or another determinant — a question that only makes sense once you can already read a shift versus a movement correctly on the demand-and-supply diagram covered here. Weakness in 2.1-2.3 is one of the most common reasons students later struggle with elasticity calculations and diagrams.

Exam traps

• Confusing a shift of a curve with a movement along it — always identify which determinant changed.
• Drawing demand and supply curves the wrong way round (demand slopes down, supply slopes up).
• Forgetting “ceteris paribus” — every law of demand/supply statement assumes other factors are held constant.
• Not explaining the direction of adjustment (shortage → price rises; surplus → price falls) when asked to analyse a market change.
• Forgetting to state which of the price mechanism’s three functions (signalling, incentive, rationing) is relevant when a question specifically asks about the role of price in a market.
• Ambiguous “both curves shift” scenarios answered as if only one curve moved — always check whether the question describes a change affecting demand, supply, or both.

Self-test

1. What causes a movement along the demand curve, versus a shift of the curve?
2. State the law of supply.
3. What happens to price when there is a shortage in a competitive market?
4. Give two determinants (other than price) that could shift the demand curve.
5. Name the three functions of the price mechanism.
6. If demand shifts right while supply is unchanged, what happens to equilibrium price and quantity?

Answers: 1. A change in the good’s own price causes a movement along the curve; a change in any other determinant (income, tastes, related prices, etc.) causes the curve to shift. 2. As price rises, quantity supplied rises, ceteris paribus. 3. Price rises, as buyers compete for the limited quantity available, until the market clears at the new equilibrium. 4. Any two: income, tastes/preferences, price of substitutes or complements, population, consumer expectations. 5. Signalling, incentive, and rationing. 6. Both equilibrium price and equilibrium quantity rise.

Official syllabus

International Baccalaureate Organization, Economics guide (Diploma Programme), first assessment 2022.