Supply, demand and what prices are really doing

Economics begins with the fact that wants exceed available resources, so every choice forgoes something. Opportunity cost is the value of the best alternative given up, and it is the real cost of any decision, not the money spent.

This reframes ordinary questions. The cost of a year of study is not only tuition but the earnings forgone. The cost of a government building a hospital is whatever else that money and labour could have produced.

Demand slopes downward: as price rises, quantity demanded falls, because buyers substitute toward alternatives and because each additional unit is worth less to them. Supply slopes upward: higher prices make production worth the cost for more sellers.

Where they meet is equilibrium. Above it, unsold surplus pushes prices down; below it, shortage pushes prices up. The important insight is that nobody chooses the equilibrium price. It emerges from many independent decisions.

• A price change moves you along a curve, it does not shift it.
• Demand shifts with income, tastes, population, prices of substitutes and complements, and expectations.
• Supply shifts with input costs, technology, taxes and subsidies, and the number of sellers.
• Getting this distinction wrong is the single most common error in market questions.

Elasticity measures how much quantity responds to price. Demand is elastic when a small price change causes a large quantity change, typical of goods with close substitutes and non-essential purchases. It is inelastic for necessities, addictive goods and items with no alternatives.

This determines who really bears a tax. When demand is inelastic, sellers can pass most of a tax to buyers because they will keep purchasing. When demand is elastic, sellers absorb more or lose volume. It also explains why revenue rises with price for some goods and falls for others.

A price ceiling set below equilibrium, such as rent control, produces shortage: quantity demanded exceeds quantity supplied, and the gap is settled by queues, waiting lists, quality decline or informal markets rather than by price.

A price floor set above equilibrium, such as a minimum wage or an agricultural support price, produces surplus. These are descriptions, not verdicts. Whether a control is worthwhile depends on how large the distortion is and what distributional goal it serves, which is exactly where economic analysis hands over to political judgment.