Economics: Demand, Supply, and Market Equilibrium

🟢 Lite — Quick Review (1h–1d)

Rapid summary for last-minute revision before your exam.

Demand, Supply, and Market Equilibrium — Key Facts for Sri Lanka A/L Examination

Law of Demand:

• When price rises, quantity demanded falls (ceteris paribus)
• When price falls, quantity demanded rises (ceteris paribus)
• Inverse relationship between price and quantity demanded

Law of Supply:

• When price rises, quantity supplied rises
• When price falls, quantity supplied falls
• Direct/positive relationship between price and quantity supplied

Market Equilibrium:

• Where demand curve intersects supply curve
• Equilibrium price: Price where quantity demanded = quantity supplied
• Equilibrium quantity: Quantity at equilibrium price
• Surplus: Price above equilibrium → quantity supplied > quantity demanded
• Shortage: Price below equilibrium → quantity demanded > quantity supplied

⚡ A/L Exam Tip: Always remember “ceteris paribus” (all other things being equal) — this is critical for economic analysis!

---

🟡 Standard — Regular Study (2d–2mo)

Standard content for students with a few days to months.

Demand, Supply, and Market Equilibrium — Detailed Study Guide

The Market Mechanism

Understanding Demand:

Element	Description	Example (Rice in Sri Lanka)
Demand	Willingness and ability to buy at various prices	Households willing to buy rice at different prices
Quantity Demanded	Amount bought at a specific price	10 kg of rice at Rs. 200/kg
Price	What you pay per unit	Rs. 200 per kg
Willingness to pay	Maximum price consumer will pay	Rs. 250/kg
Ability to pay	Having enough income to afford	Income allows purchase

Demand Schedule and Curve:

• Individual demand: One consumer’s demand at each price
• Market demand: Sum of all individual demands at each price
• Law of Demand: Inverse relationship, shown by downward-sloping curve

Why Demand Curve Slopes Downward:

1. Income effect: Lower price → real income increases → more purchases
2. Substitution effect: Lower price makes good relatively cheaper than substitutes
3. Diminishing marginal utility: Additional units give less satisfaction

Determinants of Demand

Movement Along vs. Shift of Demand Curve:

Movement Along (Change in Quantity Demanded):

• Caused by change in the GOOD’S OWN PRICE
• Price increases → movement up the curve → quantity demanded decreases
• Price decreases → movement down the curve → quantity demanded increases
• Direction shown by arrows on the same curve

Shift of Demand Curve (Change in Demand):

• Caused by change in OTHER FACTORS (non-price determinants)
• Entire curve shifts right (increase) or left (decrease)
• Price remains the same but quantity demanded changes

Non-Price Determinants of Demand (Shift Factors):

Determinant	Increase in Determinant	Decrease in Determinant
Income (normal goods)	D curve shifts right	D curve shifts left
Income (inferior goods)	D curve shifts left	D curve shifts right
Price of substitutes	D curve shifts right	D curve shifts left
Price of complements	D curve shifts right	D curve shifts left
Taste and preference	D curve shifts right	D curve shifts left
Expectations (future price)	D curve shifts right	D curve shifts left
Expectations (future income)	D curve shifts right	D curve shifts left
Number of buyers	D curve shifts right	D curve shifts left
Government policy	D curve shifts right	D curve shifts left

Sri Lankan Example - Tea Demand:

• If coffee prices rise (substitute), tea demand increases (shift right)
• If household incomes rise, premium tea demand increases (shift right)
• If health warnings about tea emerge, demand decreases (shift left)

Understanding Supply

The Law of Supply:

• Producers are willing to supply more at higher prices
• Positive/direct relationship between price and quantity supplied
• Higher price → higher revenue per unit → incentive to produce more

Supply Schedule and Curve:

• Individual supply: One producer’s supply at each price
• Market supply: Sum of all individual supplies at each price
• Law of Supply: Direct relationship, shown by upward-sloping curve

Why Supply Curve Slopes Upward:

1. Rising marginal cost: Additional units cost more to produce
2. Entry of new firms: Higher prices attract new producers
3. Increased revenue: Higher price means higher total revenue

Determinants of Supply

Movement Along vs. Shift of Supply Curve:

Movement Along (Change in Quantity Supplied):

• Caused by change in the GOOD’S OWN PRICE
• Price increases → movement up the curve → quantity supplied increases
• Price decreases → movement down the curve → quantity supplied decreases

Shift of Supply Curve (Change in Supply):

• Caused by change in OTHER FACTORS (non-price determinants)
• Entire curve shifts right (increase) or left (decrease)

Non-Price Determinants of Supply (Shift Factors):

Determinant	Increase in Supply	Decrease in Supply
Cost of production	S curve shifts right	S curve shifts left
Technology	S curve shifts right	S curve shifts left
Prices of other goods	S curve shifts right	S curve shifts left
Expectations of future prices	S curve shifts right	S curve shifts left
Number of sellers	S curve shifts right	S curve shifts left
Government taxes	—	S curve shifts left
Government subsidies	S curve shifts right	—
Natural conditions	S curve shifts right	S curve shifts left
Input prices	—	S curve shifts left

Sri Lankan Example - Rice Supply:

• If fertiliser prices rise (input cost), rice supply decreases (shift left)
• If new irrigation technology is introduced, rice supply increases (shift right)
• If good monsoon (natural condition), rice supply increases (shift right)

---

🔴 Extended — Deep Study (3mo+)

Comprehensive coverage for students on a longer study timeline.

Demand, Supply, and Market Equilibrium — Complete Notes for A/L Sri Lanka

Market Equilibrium

Finding Equilibrium:

Equilibrium occurs where:
Quantity Demanded = Quantity Supplied

At this point:
- No tendency for price to change
- Market clears (no surplus, no shortage)
- Maximum possible transactions occur

Equilibrium Example (Sri Lankan Tea):

Price (Rs./kg)	Quantity Demanded (kg)	Quantity Supplied (kg)	Market Outcome
500	100	50	Shortage (50)
600	80	60	Shortage (20)
700	70	70	Equilibrium ✓
800	60	85	Surplus (25)
900	50	100	Surplus (50)

Graphical Representation:

• Equilibrium point: Where D and S curves intersect
• Equilibrium price: Vertical axis value at equilibrium
• Equilibrium quantity: Horizontal axis value at equilibrium

Market Forces: Surplus and Shortage

Surplus (Excess Supply):

• Occurs when price is ABOVE equilibrium
• Quantity supplied > quantity demanded
• Market pressure: Producers will lower prices to sell
• Price tends to fall toward equilibrium

Shortage (Excess Demand):

• Occurs when price is BELOW equilibrium
• Quantity demanded > quantity supplied
• Market pressure: Consumers will bid higher to get goods
• Price tends to rise toward equilibrium

How Markets Reach Equilibrium:

Process	Starting Point	Market Mechanism
Price falls	Above equilibrium	Surplus → producers cut price → quantity demanded rises
Price rises	Below equilibrium	Shortage → consumers offer more → quantity supplied rises

Price Ceiling and Price Floors:

Price Ceiling (Maximum price):

• Government sets maximum price (e.g., price of essential medicines)
• Only effective if set BELOW equilibrium price
• Results in shortage
• Black markets may develop

Price Floor (Minimum price):

• Government sets minimum price (e.g., guaranteed price for rice farmers)
• Only effective if set ABOVE equilibrium price
• Results in surplus
• Government must purchase surplus

Sri Lankan Price Controls:

• Price controls on subsidised food items (lowe rice, sugar, dhal)
• Attempts to control prices of essential goods
• Impact: Often create shortages or black markets

Applications of Demand and Supply

Elasticity of Demand:

Price Elasticity of Demand (PED):

• Measures how responsive quantity demanded is to price changes
• Formula: PED = % Change in QD ÷ % Change in Price
• Elastic: |PED| > 1 (quantity changes more than price)
• Inelastic: |PED| < 1 (quantity changes less than price)
• Unit elastic: |PED| = 1

Factors Affecting PED:

1. Availability of substitutes: More substitutes → more elastic
2. Necessity vs. luxury: Necessities → less elastic
3. Proportion of income: Large share → more elastic
4. Time period: Long run → more elastic (more adjustments)
5. Habit-forming goods: Less elastic (addictive)

PED Example:

• Tea in Sri Lanka: Inelastic (few substitutes, habit)
• Imported luxury biscuits: Elastic (many substitutes)

Elasticity and Tax Burden:

• Tax burden falls on party with less elastic curve
• Tax on inelastic good → mostly passed to consumers
• Tax on elastic good → mostly borne by producers

Income Elasticity of Demand (YED):

• Measures responsiveness to income changes
• YED = % Change in QD ÷ % Change in Income
• Normal goods: YED > 0 (income ↑ → QD ↑)
• Inferior goods: YED < 0 (income ↑ → QD ↓)

Cross-Price Elasticity of Demand (XED):

• Measures responsiveness to changes in OTHER GOOD’S price
• XED = % Change in QD of Good A ÷ % Change in Price of Good B
• Substitutes: XED > 0 (price of coffee ↑ → tea demand ↑)
• Complements: XED < 0 (price of sugar ↑ → tea demand ↓)

Market Failure and Government Intervention

What is Market Failure?:

• Market fails to allocate resources efficiently
• Social welfare is not maximised
• Government intervention may be justified

Types of Market Failure:

1. Public Goods:

• Cannot exclude non-payers (free-rider problem)
• Non-rivalrous (one person’s use doesn’t diminish another’s)
• Example: Street lighting, national defence
• Market under-provides public goods

2. Externalities:

• Negative externality: Private cost < social cost (pollution)
• Positive externality: Private benefit < social benefit (education)
• Market doesn’t account for external effects

3. Market Power/Monopoly:

• Single seller can control price
• Output restricted below efficient level
• Deadweight loss

4. Information Asymmetry:

• One party has more information than other
• Example: Used car seller knows more than buyer
• Can lead to adverse selection

5. Inequality and Equity Concerns:

• Market outcomes may be unfair
• Merit wants vs. effective demand
• Basic needs may go unmet

Government Interventions in Sri Lanka:

Policy	Example	Intended Effect
Price controls	Subsidised food prices	Protect poor consumers
Taxes	VAT, excise taxes	Raise revenue, discourage goods
Subsidies	Fertiliser subsidy for farmers	Lower production costs
Regulations	Consumer protection laws	Correct information asymmetry
Public provision	Free education, public healthcare	Provide public goods/merit goods

Consumer and Producer Surplus:

Consumer Surplus:

• Difference between what consumer is willing to pay and what they actually pay
• Area below demand curve, above price line
• Total welfare to consumers

Producer Surplus:

• Difference between what producer is willing to accept and what they actually receive
• Area above supply curve, below price line
• Total welfare to producers

Total Surplus = Consumer Surplus + Producer Surplus:

• Maximum when market is at equilibrium
• Government intervention reduces total surplus (deadweight loss)

Advanced: Simultaneous Shifts

When Both Curves Shift:

• D shifts right, S shifts right:

  • Price ambiguous (depends on magnitude of shifts)
  • Quantity definitely increases

• D shifts right, S shifts left:

  • Price definitely increases
  • Quantity ambiguous

• D shifts left, S shifts right:

  • Price definitely decreases
  • Quantity ambiguous

• D shifts left, S shifts left:

  • Price ambiguous
  • Quantity definitely decreases

Analysis Approach:

1. Identify which curve(s) shift
2. Determine direction of shift (right or left)
3. Identify new equilibrium
4. Compare new equilibrium to original
5. State effects on price and quantity

Sri Lankan Example - Tea Market:

• Increase in global demand for tea (D shifts right)
• New technology reduces production cost (S shifts right)
• Effect on quantity: Definitely increases
• Effect on price: Ambiguous (depends on magnitude of shifts)

⚡ A/L Exam Tip: For “explain” questions, always use diagrams AND words. Draw the diagram, label everything, then explain what happened!

---

Content adapted based on your selected roadmap duration. Switch tiers using the selector above.