Understanding demand and supply

Nearly every market question comes back to demand and supply. If you can draw the two curves, move the right one and read off the new price, you can answer a large part of the paper. The mistake that costs the most marks is moving a curve when the question only asked for a movement along it.

What the demand curve shows

Demand is how much of a good buyers are willing and able to buy at each price, over a given period. Willing and able is the part students skip. Wanting a car is not demand. Wanting a car and having the money for it is.

The curve slopes downwards. When the price falls, people who already buy the good tend to buy more, and people who could not afford it before can now join in. Put price on the vertical axis and quantity on the horizontal axis, label them P and Q, and label the line D. Marks are given for those labels, so write them every single time.

Movement along, or a shift

This is what examiners test most. Only one thing causes a movement along the curve: a change in the price of the good itself. Nothing else.

• The price rises, so you move up the demand curve to a smaller quantity. This is a contraction, or a fall in quantity demanded.
• The price falls, so you move down the curve to a larger quantity. This is an extension, or a rise in quantity demanded.

Anything that is not the price of the good itself shifts the whole curve left or right. A shift means people now buy a different amount at every price, not just at one price.

What shifts demand

• Income. When income rises, demand for normal goods rises and the curve shifts right. Demand for inferior goods falls, because people switch to something better.
• The price of a substitute. If tea gets dearer, some people drink coffee instead, so demand for coffee shifts right.
• The price of a complement. Complements are used together. If petrol gets much dearer, demand for large cars shifts left.
• Tastes, fashion and advertising.
• The size and age structure of the population.
• What people expect prices to do next. If buyers think sugar will cost more next month, demand for sugar shifts right now.

What shifts supply

Supply is how much producers are willing and able to sell at each price. The supply curve slopes upwards, because a higher price makes selling worthwhile and helps cover the cost of producing extra units.

• Costs of production. Higher wages, dearer raw materials or a new indirect tax shift supply left.
• Technology. Better machines or methods cut the cost per unit and shift supply right.
• Subsidies. A payment from the government to the producer shifts supply right.
• Weather and natural events, which matter most for farm products.
• The number of firms in the market.

Putting the two together

Where the curves cross you get the equilibrium price and quantity. At that price, the amount buyers want to buy equals the amount sellers want to sell, so nothing pushes the price either way.

If the price sits above equilibrium there is a surplus. Sellers cannot sell everything they made, so they cut the price and the market slides back down. If the price sits below equilibrium there is a shortage. Buyers compete for the little that is there and the price is pushed up.

How to write the answer

Work in the same order every time. Say which curve moves. Say which way. Say why. Then say what happens to price and quantity.

Here is the whole thing in one sentence: a rise in bakers' wages raises the cost of making bread, so the supply of bread shifts left, the equilibrium price rises and the equilibrium quantity falls.

Draw the diagram before you write the words. It is quicker, and it stops your writing contradicting your diagram. Label the first equilibrium P1 and Q1 and the new one P2 and Q2, and put an arrow on the curve that moved.

One last thing about O Level. Demand and supply diagrams are needed in plenty of places on the 2281 syllabus, but the syllabus says they are not required for market failure. At A Level you use the same diagrams and then add an indirect tax, a subsidy, a maximum price or a minimum price on top of them.