1.5 Microeconomics: Price, Supply, Demand & Elasticity
Key Takeaways
- Market price is set where the downward-sloping demand curve intersects the upward-sloping supply curve; a surplus above that price and a shortage below it both push price back toward equilibrium.
- A change in price causes a movement ALONG a curve, whereas a change in any other determinant — income, substitute prices, input costs, technology, expectations — SHIFTS the entire curve to a new equilibrium.
- Price elasticity of demand is the percentage change in quantity divided by the percentage change in price; demand is elastic when the absolute value exceeds 1 and inelastic when it is below 1.
- Raising price increases total revenue only where demand is inelastic; where demand is elastic a price rise destroys revenue, which is why pricing power is the central question in equity analysis.
- Necessities, addictive goods, products with few substitutes and purchases forming a small share of income all exhibit inelastic demand, while discretionary goods with close substitutes are highly elastic.
1.5 Microeconomics: Price, Supply, Demand & Elasticity
Macroeconomics explains the tide; microeconomics explains why one boat rises faster than another. The ICWIM syllabus requires candidates to know how price is determined and the interaction of supply and demand — and the same apparatus is what an equity analyst is actually using when they ask whether a company can raise prices without losing customers.
The Demand Curve
Demand is the quantity of a good that buyers are willing and able to purchase at each price, over a defined period. Plotted with price on the vertical axis and quantity on the horizontal, the demand curve slopes downward for two reasons:
- The substitution effect. As a good becomes more expensive relative to alternatives, buyers switch away from it.
- The income effect. A higher price reduces real purchasing power, so less of the good can be afforded out of an unchanged money income.
The Supply Curve
Supply is the quantity producers are willing and able to offer at each price. The supply curve slopes upward because a higher price covers the rising marginal cost of expanding output and draws additional producers into the market.
Equilibrium: Where the Curves Cross
The market clears at the price where quantity demanded equals quantity supplied. Away from that point the market is self-correcting:
| Condition | What happens to quantity | Market pressure |
|---|---|---|
| Price above equilibrium | Quantity supplied exceeds quantity demanded — a surplus | Unsold stock forces sellers to cut prices |
| Price at equilibrium | Quantity supplied equals quantity demanded | Stable; the market clears |
| Price below equilibrium | Quantity demanded exceeds quantity supplied — a shortage | Queues and rationing let sellers raise prices |
Movements Along a Curve versus Shifts of a Curve
This is the single most heavily examined distinction in microeconomics, and the one candidates most often get wrong.
- A change in the good's own price causes a movement along the existing curve. Economists call this a change in quantity demanded, not a change in demand.
- A change in any other determinant causes the whole curve to shift to a new position, producing a new equilibrium price and quantity. This is a change in demand.
Determinants that shift the demand curve
| Determinant | Rightward shift (demand increases) when… |
|---|---|
| Consumer income | Income rises, for a normal good. For an inferior good (own-brand staples, bus travel) rising income shifts demand left |
| Price of substitutes | A rival product becomes more expensive |
| Price of complements | A partner product becomes cheaper (cheaper petrol lifts demand for large cars) |
| Tastes and fashion | The product becomes more desirable |
| Population and demographics | The buyer pool grows |
| Expectations | Buyers expect future prices, or their own future incomes, to rise |
| Credit conditions | Borrowing becomes cheaper or more available |
Determinants that shift the supply curve
Input and raw material costs, wage rates, technology and productivity, taxes and subsidies, the number of competing producers, the prices of goods the same plant could make instead, and — for agriculture and energy — weather and geopolitical disruption.
Reading a real market
When both curves move at once, one outcome is determined and the other is ambiguous. If demand rises and supply falls, price unambiguously rises but the change in quantity depends on which shift is larger. A wealth manager reading a commodity market is doing exactly this decomposition: is the oil price rising because of Asian demand growth (bullish for producers' volumes) or because of an OPEC supply cut (bullish for price, bearish for volumes)?
Price Elasticity of Demand (PED)
Knowing that demand falls when price rises is not enough; the investment question is by how much.
PED is normally negative, and by convention it is discussed as an absolute value.
Worked example. A premium spirits brand raises the price of a bottle from £40.00 to £44.00 and unit sales fall from 100,000 to 94,000.
Revenue before: 100,000 × £40 = £4.0m. Revenue after: 94,000 × £44 = £4.136m. Because demand is inelastic, the price increase raised revenue.
| PED (absolute value) | Classification | Effect of a price increase on total revenue |
|---|---|---|
| 0 | Perfectly inelastic | Revenue rises proportionally with price |
| Between 0 and 1 | Inelastic | Revenue rises |
| Exactly 1 | Unit elastic | Revenue unchanged |
| Greater than 1 | Elastic | Revenue falls |
| Infinite | Perfectly elastic | Revenue collapses to zero |
What makes demand inelastic
- Few or poor substitutes — patented medicines, a monopoly utility, a dominant index provider.
- Necessity rather than luxury — insulin against cruise holidays.
- Addictive or habitual consumption — tobacco, caffeine.
- A small share of the buyer's budget — salt, screws, and most software seat licences.
- A short time horizon — demand is almost always more elastic in the long run, once buyers can re-engineer around the price.
- Brand strength — the entire economic content of the phrase "pricing power".
Related elasticities
- Income elasticity of demand: percentage change in quantity over percentage change in income. Above +1 marks a luxury (high-end retail, premium travel — highly cyclical); between 0 and +1 a necessity (utilities, staples — defensive); negative an inferior good (which can be counter-cyclical).
- Cross elasticity of demand: positive for substitutes, negative for complements. A large positive cross elasticity against a rival's price is the quantitative definition of a commoditised, competitive market.
- Price elasticity of supply: low where capacity takes years to build (mining, semiconductors, shipping), which is why supply shocks in those industries produce violent and persistent price spikes.
Why This Sits in a Wealth Management Exam
The elasticity concept is the bridge from economics to security selection:
- Inelastic demand plus a strong brand equals pricing power, and pricing power is what allows a company to pass input cost inflation through to customers and protect its gross margin. It is the single most reliable defence against an inflationary macro regime.
- Income elasticity predicts cyclicality. A portfolio's defensive sleeve is, in economic terms, a collection of low-income-elasticity businesses.
- Elastic demand plus high fixed costs is the classic value trap: any attempt to raise price destroys volume, and any attempt to hold volume destroys margin.
A government announces a large increase in the excise duty levied on cigarette manufacturers. Holding all else equal, how should an analyst expect the cigarette market to react, and why?
A subscription software business raises its annual licence fee from £500 to £550 and observes that its customer count falls from 40,000 to 38,000. What is the price elasticity of demand, and what happened to total revenue?
Which of the following would cause the demand curve for new passenger cars to shift to the right rather than produce a movement along the existing curve?