Cambridge Syllabus Notes

Demand and Supply – Effective Demand

Learning objectives

Define **effective demand** and distinguish it from mere willingness to buy.
Explain the shape and behaviour of the demand and supply curves.
Identify the determinants that shift each curve.
Calculate and interpret price, income and cross‑price elasticities of demand and the price elasticity of supply.
Analyse the welfare implications of market equilibrium (consumer & producer surplus).
Predict the effect of simultaneous shifts in demand and supply.
Link elasticity concepts to government intervention (taxes, subsidies, price controls).

1. Effective demand

Effective demand is the quantity of a good or service that consumers are both willing and able to purchase at a given price, over a specified period. “Ability to pay’’ incorporates income, wealth, or access to credit. The syllabus stresses the contrast:

Willingness to buy – a desire for the good at a particular price.
Ability to pay – the financial resources to actually make the purchase.

Only when the two coincide do we have **effective demand**.

2. The demand curve

Definition: Graph of the relationship between the price of a good (P) and the quantity demanded (Q_d) when all non‑price determinants are held constant.
Law of demand (ceteris paribus): A lower price leads to a higher quantity demanded – the curve slopes downwards.
Movement vs. shift
- Movement along the curve – caused by a change in the good’s own price.
- Shift of the curve – caused by a change in any non‑price determinant (income, tastes, expectations, etc.).

3. The supply curve

Definition: Graph of the relationship between the price of a good (P) and the quantity supplied (Q_s) when all non‑price determinants are held constant.
Law of supply (ceteris paribus): A higher price induces producers to supply more – the curve slopes upwards.
Movement vs. shift
- Movement along the curve – caused by a change in the good’s own price.
- Shift of the curve – caused by a change in any non‑price determinant (input costs, technology, number of sellers, etc.).

4. Determinants of effective demand (shifts of the demand curve)

Determinant	Direction of shift	Explanation
Income – normal goods	Right (increase)	Higher income raises purchasing power, so more can be bought at each price.
Income – inferior goods	Left (decrease)	Higher income leads consumers to switch to higher‑quality alternatives.
Prices of related goods	Substitutes: left; Complements: right	A cheaper substitute reduces demand for the original; a cheaper complement raises it.
Consumer preferences & expectations	Right or left	Changes in tastes, advertising, or expectations about future price/availability shift demand.
Population (size & composition)	Right if population grows; left if it falls	More consumers or a larger proportion of buyers raise total demand.
Future price expectations	Right if price expected to rise; left if expected to fall	Anticipating higher future prices encourages current purchases.

5. Determinants of supply (shifts of the supply curve)

Determinant	Direction of shift	Explanation
Input prices	Higher cost → left; lower cost → right	Higher costs make production less profitable, reducing supply.
Technology	Improvement → right	More efficient production raises output at each price.
Number of sellers	More sellers → right; fewer sellers → left	More firms increase total market supply.
Expectations of future prices	Expected rise → left (hold back); expected fall → right	Producers may withhold output if they expect higher future prices.
Taxes & subsidies	Tax ↑ → left; subsidy ↑ → right	Taxes raise marginal cost; subsidies lower it.
Time horizon	Short‑run: less responsive; Long‑run: more responsive	In the long run firms can adjust plant size and factors of production.

6. Elasticities of demand

Elasticities measure the responsiveness of quantity demanded to a change in price, income or the price of another good.

Price elasticity of demand (PED) $$\varepsilon_{P}= \frac{\%\Delta Q_{d}}{\%\Delta P}$$ Interpretation
- |$\varepsilon_{P}$| > 1 – **elastic** (quantity changes more than price).
- |$\varepsilon_{P}$| = 1 – **unit‑elastic**.
- |$\varepsilon_{P}$| < 1 – **inelastic** (quantity changes less than price).
- $\varepsilon_{P}=0$ – perfectly inelastic (vertical demand curve).
- $\varepsilon_{P}=-\infty$ – perfectly elastic (horizontal demand curve).
Sign – PED is negative because price and quantity demanded move in opposite directions (law of demand). Revenue implication –
- If |$\varepsilon_{P}$| > 1, a price fall **increases** total revenue.
- If |$\varepsilon_{P}$| < 1, a price fall **decreases** total revenue.
Income elasticity of demand (YED) $$\varepsilon_{Y}= \frac{\%\Delta Q_{d}}{\%\Delta Y}$$ Interpretation
- $\varepsilon_{Y}>0$ – normal good (demand rises with income).
- $\varepsilon_{Y}<0$ – inferior good (demand falls with income).
Cross‑price elasticity of demand (XED) $$\varepsilon_{X}= \frac{\%\Delta Q_{d}^{A}}{\%\Delta P^{B}}$$ Interpretation
- $\varepsilon_{X}>0$ – goods A and B are **substitutes**.
- $\varepsilon_{X}<0$ – goods A and B are **complements**.

7. Price elasticity of supply (PES)

$$\varepsilon_{S}= \frac{\%\Delta Q_{s}}{\%\Delta P}$$

Typically higher in the long run because firms can adjust capacity, enter/exit the market, and adopt new technology.
Key determinants: spare capacity, time period, flexibility of input prices, and technological change.

8. Welfare analysis – Consumer and Producer Surplus

At equilibrium price $P^{*}$ and quantity $Q^{*}$:

Consumer surplus (CS) – the area between the demand curve and the price line up to $Q^{*}$. It measures the extra benefit consumers receive because they are willing to pay more than the market price.
Producer surplus (PS) – the area between the supply curve and the price line up to $Q^{*}$. It measures the extra benefit producers receive because they are willing to sell for less than the market price.

Graphically, CS and PS form the two “welfare triangles’’ on either side of the equilibrium point. In a perfectly competitive market, the sum CS + PS represents the total economic surplus (allocative efficiency). Any shift that creates a shortage or surplus reduces total surplus and generates a dead‑weight loss.

9. Interaction of demand and supply – market equilibrium

Market equilibrium is where effective demand equals effective supply:

$$Q_{d}(P^{*}) = Q_{s}(P^{*}) = Q^{*}$$

At this point there is no excess demand (shortage) or excess supply (surplus). The equilibrium price and quantity are determined by the intersection of the demand and supply curves.

9.1 Simultaneous shifts

Both demand and supply increase: equilibrium quantity rises; the effect on price is ambiguous – it depends on which shift is larger.
Demand increases, supply decreases: both equilibrium price and quantity rise.
Demand decreases, supply increases: both equilibrium price and quantity fall.

9.2 Diagrammatic illustration (suggested)

Diagram 1 – Initial equilibrium (E) where D meets S.
Diagram 2 – Right‑ward shift of demand to D′ (ceteris paribus) → higher price (P′) and quantity (Q′).
Diagram 3 – Simultaneous right‑ward shifts of D to D′ and S to S′ – quantity rises, price change depends on relative magnitudes.

10. Link‑on: Elasticity and government intervention

Understanding elasticities is essential when analysing the impact of:

Taxes – The more inelastic the demand (or supply), the larger the burden on the side that is less responsive.
Subsidies – Benefit is greater when the subsidised side is price‑elastic.
Price controls (ceilings & floors) – The size of the resulting surplus or shortage depends on the elasticities of demand and supply.

11. Worked example – calculating elasticities

Demand function: $Q_{d}=200-5P+0.2Y$ (P in £, Y in £ 000).

Income elasticity at $P=20$, $Y=20$ $$\varepsilon_{Y}= \frac{0.2Y}{200-5P+0.2Y}\times\frac{Y}{\Delta Y} =\frac{0.2(20)}{200-5(20)+0.2(20)}\approx0.19$$ Positive → the good is a **normal good** (but relatively income‑inelastic).
Price elasticity at the same point $$\varepsilon_{P}= \frac{-5P}{200-5P+0.2Y}\times\frac{P}{\Delta P} =\frac{-5(20)}{200-5(20)+0.2(20)}\approx-0.71$$ |$\varepsilon_{P}$| < 1 → **inelastic demand**; a price rise would increase total revenue.
Effect of an income rise to £30 000 New demand: $Q_{d}'=200-5P+0.2(30)=206-5P$. The intercept rises from 200 to 206 – a right‑ward shift of the demand curve.

12. Summary – key points to remember

Effective demand = willingness + ability to pay.
Demand curves slope downwards; supply curves slope upwards.
Only non‑price factors shift the curves; price changes cause movements along them.
Elasticities quantify responsiveness; the sign of PED is negative, and its magnitude tells us how total revenue responds to price changes.
Consumer and producer surplus measure the welfare generated by market exchange; any distortion creates dead‑weight loss.
An increase in effective demand (right shift) raises equilibrium price and quantity, provided supply remains upward‑sloping.
Simultaneous shifts can affect price, quantity, or both – always assess the relative magnitude of the shifts.
Elasticities are the bridge between micro‑theory and government policy (taxes, subsidies, price controls).

13. Extension – A‑Level topics (for combined AS + A‑Level courses)

Utility & indifference curves – marginal rate of substitution, convexity, and how they underpin the demand curve.

Market failure – externalities, public goods, information asymmetry; welfare loss illustrated with supply‑demand diagrams.

Market structures – characteristics of perfect competition, monopolistic competition, oligopoly and monopoly; brief note on how price‑setting behaviour alters the demand curve faced by firms.

Macroeconomic foundations – reminder that this note set focuses on micro‑economics; later sections will cover aggregate demand & supply, inflation, unemployment, and fiscal/monetary policy.

International trade & balance of payments – a “further reading” cue directing students to the next module on trade, tariffs, quotas, current‑account and exchange‑rate mechanisms.

14. Further reading & practice

Cambridge AS & A Level Economics (9708) – Chapter 2: “Demand, Supply and Market Equilibrium”.
Past paper questions on elasticity, consumer/producer surplus and tax incidence (e.g., 2019 June, Paper 1, Q7).
Online interactive simulations (e.g., Econland, Tutor2U) to visualise simultaneous shifts and welfare triangles.

effective demand