Economic Fundamentals
The building blocks of all economic thinking: supply, demand, markets, and prices.
Supply and Demand
The most important concept in economics. Everything else builds on this.
Demand
Demand is how much of a product consumers are willing and able to buy at different prices.
| Price | Quantity Demanded | Why |
|---|---|---|
| $100 | 10 units | Few can afford it |
| $75 | 25 units | More buyers enter |
| $50 | 50 units | Affordable for many |
| $25 | 100 units | Almost everyone can buy |
| $10 | 200 units | Impulse buys increase |
Law of Demand: As price goes up, quantity demanded goes down (and vice versa).
Why Demand Curves Slope Downward
| Reason | Explanation |
|---|---|
| Substitution effect | Higher price makes alternatives attractive |
| Income effect | Higher price means less purchasing power |
| Diminishing marginal utility | Each additional unit gives less satisfaction |
| New buyers at lower prices | More people can afford the product |
Supply
Supply is how much producers are willing and able to sell at different prices.
| Price | Quantity Supplied | Why |
|---|---|---|
| $100 | 200 units | High profit, max production |
| $75 | 150 units | Still profitable |
| $50 | 75 units | Marginal producers exit |
| $25 | 30 units | Only lowest-cost producers remain |
| $10 | 5 units | Almost no one can profit |
Law of Supply: As price goes up, quantity supplied goes up (and vice versa).
Why Supply Curves Slope Upward
| Reason | Explanation |
|---|---|
| Profit motive | Higher prices attract more producers |
| Marginal cost | Each additional unit costs more to produce |
| Resource constraints | Expansion requires more expensive inputs |
| Opportunity cost | Higher prices justify leaving other activities |
Market Equilibrium
Where supply meets demand, you find the equilibrium price and equilibrium quantity.
Finding Equilibrium
| Price | Quantity Demanded | Quantity Supplied | Result |
|---|---|---|---|
| $80 | 20 | 180 | Surplus (160 unsold) |
| $60 | 60 | 120 | Surplus (60 unsold) |
| $40 | 100 | 100 | Equilibrium |
| $20 | 160 | 40 | Shortage (120 unmet) |
| $10 | 200 | 10 | Shortage (190 unmet) |
What Happens Away from Equilibrium
| Situation | Definition | Market Response |
|---|---|---|
| Surplus | Supply > Demand | Prices fall, production decreases |
| Shortage | Demand > Supply | Prices rise, production increases |
| Equilibrium | Supply = Demand | Stable until conditions change |
Key insight: Markets naturally move toward equilibrium. No central planner needed.
Shifts vs. Movements
This distinction trips up most beginners.
Movement Along a Curve
A change in price causes movement along the existing curve.
- Price rises: move up the demand curve (less demanded)
- Price falls: move down the demand curve (more demanded)
Shift of the Curve
A change in other factors shifts the entire curve.
Factors that shift demand:
| Factor | Shift Right (More Demand) | Shift Left (Less Demand) |
|---|---|---|
| Income | Income rises (normal goods) | Income falls |
| Preferences | Product becomes trendy | Product falls out of favor |
| Substitutes | Substitute price rises | Substitute price falls |
| Complements | Complement price falls | Complement price rises |
| Expectations | Expected future shortage | Expected future surplus |
| Population | More potential buyers | Fewer potential buyers |
Factors that shift supply:
| Factor | Shift Right (More Supply) | Shift Left (Less Supply) |
|---|---|---|
| Input costs | Raw materials cheaper | Raw materials expensive |
| Technology | Better production methods | Technology fails/degrades |
| Taxes/subsidies | Subsidies increase | Taxes increase |
| Number of sellers | New firms enter market | Firms exit market |
| Expectations | Expected price decline | Expected price increase |
| Natural events | Favorable weather | Drought, disaster |
Elasticity
Elasticity measures how responsive quantity is to price changes.
Price Elasticity of Demand
| Elasticity Type | Definition | Example |
|---|---|---|
| Elastic (> 1) | Quantity changes more than price | Luxury goods, items with substitutes |
| Inelastic (< 1) | Quantity changes less than price | Necessities, addictive goods |
| Unit elastic (= 1) | Quantity changes same as price | Rare in practice |
| Perfectly elastic | Any price increase kills demand | Perfect substitutes |
| Perfectly inelastic | Price doesn't affect quantity | Life-saving medicine |
Factors Affecting Elasticity
| Factor | More Elastic | Less Elastic |
|---|---|---|
| Availability of substitutes | Many substitutes | Few substitutes |
| Necessity vs. luxury | Luxury | Necessity |
| Time horizon | Long run | Short run |
| Budget share | Large purchase | Small purchase |
| Definition of market | Narrow (Coke) | Broad (beverages) |
Why Elasticity Matters
| Decision | Elastic Demand | Inelastic Demand |
|---|---|---|
| Raise prices | Revenue falls | Revenue rises |
| Lower prices | Revenue rises | Revenue falls |
| Tax burden | Falls more on producers | Falls more on consumers |
Price Controls
Government-mandated prices that differ from equilibrium.
Price Ceilings (Maximum Prices)
| Aspect | Description |
|---|---|
| Definition | Legal maximum price |
| Intent | Make goods affordable |
| Example | Rent control, drug price caps |
| Effect when binding | Creates shortage |
| Side effects | Black markets, quality decline, rationing |
Example: Rent Control
| Market Rent | $2,000 |
|---|---|
| Rent Ceiling | $1,500 |
| Demand at $1,500 | 10,000 units |
| Supply at $1,500 | 6,000 units |
| Shortage | 4,000 units |
| Results | Long wait lists, discrimination, deteriorating buildings |
Price Floors (Minimum Prices)
| Aspect | Description |
|---|---|
| Definition | Legal minimum price |
| Intent | Protect sellers' income |
| Example | Minimum wage, agricultural price supports |
| Effect when binding | Creates surplus |
| Side effects | Unemployment, unsold inventory |
Example: Minimum Wage
| Market Wage | $10/hour |
|---|---|
| Minimum Wage | $15/hour |
| Workers wanting jobs | 1 million |
| Jobs offered | 800,000 |
| Unemployment | 200,000 workers |
| Results | Some workers earn more, others lose jobs |
Markets and Efficiency
What Markets Do Well
| Function | How Markets Achieve It |
|---|---|
| Allocate resources | Price signals direct resources to highest value |
| Coordinate activity | No central planner needed |
| Incentivize innovation | Profit rewards improvement |
| Transmit information | Prices aggregate dispersed knowledge |
| Adjust to change | Prices respond to new conditions |
Market Failures
Markets don't always work perfectly.
| Failure | Definition | Example |
|---|---|---|
| Externalities | Costs/benefits to third parties | Pollution, education |
| Public goods | Non-excludable, non-rival | National defense, lighthouses |
| Monopoly | Single seller, no competition | Utility companies |
| Information asymmetry | One party knows more | Used car sales, insurance |
| Common resources | Rival but non-excludable | Fisheries, common land |
Externalities in Detail
| Type | Definition | Example | Solution |
|---|---|---|---|
| Negative | Harm to third parties | Factory pollution | Tax, regulation |
| Positive | Benefit to third parties | Flu vaccine, education | Subsidize |
Key insight: When externalities exist, private markets produce too much of bad things and too little of good things.
Thinking Like an Economist
Core Principles
| Principle | Meaning | Example |
|---|---|---|
| Trade-offs | Every choice has a cost | Guns vs. butter |
| Opportunity cost | Value of next best alternative | Time spent studying vs. working |
| Marginal thinking | Decisions on the next unit | One more hour of work? |
| Incentives matter | People respond to rewards/penalties | Tax breaks change behavior |
| Trade creates value | Voluntary exchange benefits both | You value coffee more than $5, seller values $5 more |
| Specialization | Focus on what you do best | Comparative advantage |
Common Mistakes
| Mistake | Correction |
|---|---|
| Ignoring opportunity cost | Every choice costs something |
| All-or-nothing thinking | Most decisions are marginal |
| Focusing only on intentions | Look at incentives and outcomes |
| Ignoring unintended consequences | Every action has side effects |
| Zero-sum thinking | Trade and growth create value |
| Confusing correlation with causation | Ice cream and crime both rise in summer |
Key Takeaways
Supply and demand determine prices - Markets find equilibrium through voluntary exchange, no central planning required
Distinguish shifts from movements - Price changes cause movement along curves; other factors shift the entire curve
Elasticity predicts responses - Whether quantity responds strongly or weakly to price depends on substitutes, necessity, and time
Price controls create problems - Ceilings cause shortages, floors cause surpluses; both create unintended consequences
Markets fail sometimes - Externalities, public goods, monopoly, and information problems justify some intervention
Think on the margin - Decisions are about the next unit, not all-or-nothing
Every choice has an opportunity cost - What you give up is as important as what you get