Unit 2: Supply and Demand

Students will learn the basis for understanding how markets work with an introduction to the supply and demand model.

Demand

The Law of Demand

The law of demand states that, ceteris paribus (all else held equal), when the price of a good falls, the quantity demanded rises, and when the price rises, the quantity demanded falls. This inverse relationship is explained by both the substitution effect (consumers switch to relatively cheaper goods) and the income effect (lower prices increase real purchasing power). The law of demand underlies the downward slope of the demand curve on a graph with price on the vertical axis and quantity on the horizontal axis. Always emphasize that “demand” means the entire curve, while “quantity demanded” refers to a specific point on the curve.
It is important to recognize that the law of demand is not absolute—some goods such as Giffen goods (theoretical) or Veblen goods (luxury status items) may not follow this law. However, for nearly all normal consumer goods in AP Micro, the inverse relationship holds. Using clear language on exams, you should distinguish between changes in demand (curve shifts) and changes in quantity demanded (movements along the curve due to price changes). This distinction is a common area where students lose points.

Demand Schedules and Demand Curves

A demand schedule is a table showing the quantity demanded of a good at different prices. When graphed, it becomes the demand curve, which typically slopes downward from left to right. Each point on the curve represents the maximum quantity consumers are willing and able to purchase at a specific price. This visual representation makes the law of demand easy to apply in practice.
The demand curve can shift rightward (increase in demand) or leftward (decrease in demand) due to factors other than the good’s own price. These shifts capture changes in underlying market conditions such as consumer preferences, income, or the price of related goods. Students should be able to sketch and label these shifts quickly, explaining both the cause and the direction of the shift. Connecting table data to graphs is a key skill for AP problems.

Determinants of Demand (Shifters)

The main determinants of demand are consumer income, tastes and preferences, expectations of future prices, the number of buyers in the market, and the prices of related goods (substitutes and complements). Economists often use the acronym “INSECT” (Income, Number of buyers, Substitutes/complements, Expectations, Consumer tastes, Taxes/policies) to remember them. Each determinant shifts the whole demand curve rather than moving along it. On exam questions, you should always specify which factor changed and why it shifts demand.
For example, if consumers expect prices to rise in the future, they may demand more today, shifting demand rightward. If the number of consumers increases, as in a growing population, demand for many goods will rise. If a substitute’s price increases (like Pepsi becoming more expensive), demand for Coke will rise as consumers switch. Conversely, if a complement’s price rises (like hot dog buns), demand for hot dogs will fall.
Be careful not to confuse determinants of demand with determinants of supply. A change in production costs affects supply, not demand, while a change in consumer preferences affects demand, not supply. Always clearly label which side of the market is shifting. This avoids one of the most common mistakes students make.

Normal vs. Inferior Goods

A normal good is one where demand increases as consumer income rises. Examples include clothing, electronics, and restaurant meals. Most goods are normal, and their demand curves shift outward as incomes grow. This reflects higher purchasing power and a greater ability to buy higher quality goods.
An inferior good is one where demand decreases as consumer income rises. Examples include used cars, instant noodles, or bus tickets (if consumers switch to flights or private vehicles). As incomes rise, consumers substitute away from these goods toward more desirable alternatives. On AP exams, correctly labeling a good as normal or inferior in context is crucial when interpreting demand shifts caused by income changes.

Substitutes vs. Complements

Substitutes are goods that can replace each other, such as butter and margarine. When the price of one rises, the demand for its substitute increases. Graphically, the demand curve for the substitute shifts rightward. Substitutes embody the substitution effect within the law of demand.
Complements are goods consumed together, such as smartphones and phone cases. When the price of one rises, the demand for the other falls because consumers buy fewer pairs. Graphically, the demand curve for the complement shifts leftward. This relationship highlights how interconnected goods can be in consumer decisions.

Market Demand

Market demand is the horizontal summation of all individual demand curves. At each price level, the quantities demanded by all consumers are added to get the total market demand. As more buyers enter or leave the market, the demand curve shifts right or left accordingly. This makes the number of buyers a major determinant of overall demand.
Market demand curves tend to be smoother and more stable than individual curves because they aggregate many different consumers with different preferences. However, large shifts in income, population, or expectations can still move the entire curve significantly. Policy makers use market demand to predict the effects of taxes, subsidies, and regulations on whole industries. For AP exams, you may be asked to distinguish between individual and market demand.

Supply

The Law of Supply

The law of supply states that, ceteris paribus, when the price of a good rises, the quantity supplied rises, and when the price falls, the quantity supplied falls. This positive relationship arises because higher prices make production more profitable, encouraging firms to produce and sell more. At lower prices, some firms exit the market or reduce output, so total quantity supplied decreases. This relationship explains why supply curves typically slope upward.
It is important to note that the law of supply assumes that production costs do not change in ways that outweigh the price effect. In the short run, some inputs are fixed, but as price increases, firms can use existing capacity more intensively. In the long run, more firms can enter the industry, reinforcing the upward-sloping nature of supply. Always connect the law of supply to the incentives of producers, which contrast with the consumer incentives that shape demand.

Supply Schedules and Supply Curves

A supply schedule is a table that shows the quantity a producer (or the entire market) is willing to supply at different prices. When graphed, this becomes the supply curve, which typically slopes upward. Each point on the curve represents the minimum price at which producers are willing to supply a given quantity. The curve shows the willingness to sell, which reflects the costs of production.
The supply curve can shift rightward (increase in supply) or leftward (decrease in supply) when factors other than the good’s own price change. These shifts represent changes in producers’ ability or willingness to supply. Understanding how to move between tables and graphs is essential for clear explanations on exams. This skill is especially tested in combination with demand shifts and equilibrium analysis.

Determinants of Supply (Shifters)

Non-price factors that shift supply include input prices, technology, taxes and subsidies, expectations of future prices, the number of producers, and natural or political disruptions. If input costs fall (e.g., cheaper raw materials), supply increases because production becomes less expensive. If input costs rise, supply decreases. This connects supply to cost structures that will be studied in detail later in AP Micro.
Technology improvements lower costs and increase productivity, shifting supply to the right. Taxes raise production costs, decreasing supply, while subsidies lower costs, increasing supply. Expectations matter too: if producers expect higher future prices, they may withhold supply now, decreasing current supply. Similarly, more firms entering a market shifts supply outward, while firms leaving shifts it inward.
External shocks like natural disasters, wars, or government regulations can sharply reduce supply by destroying capacity or raising compliance costs. Conversely, stable institutions and efficient logistics can expand supply by reducing uncertainty and transaction costs. Always identify whether a change affects supply directly (production side) or demand (consumer side) to avoid common errors. Mislabeling a shift is one of the most frequent AP mistakes.

Individual vs. Market Supply

Individual supply shows how a single producer responds to prices, while market supply aggregates across all producers. Market supply is the horizontal summation of all individual curves at each price. As more firms enter an industry, the market supply curve shifts to the right, expanding output at each price level. This dynamic explains why competitive industries are responsive to price changes over time.
Market supply tends to be smoother than individual supply because it averages out firm-level differences. However, changes in input markets, such as wage increases for labor or energy price shocks, affect nearly all firms and shift the entire market supply curve. Exam questions often require you to distinguish between individual producer decisions and the aggregate market effect. Practicing both views ensures stronger understanding.

Short-Run vs. Long-Run Supply

In the short run, at least one input is fixed, so firms cannot fully adjust capacity. This makes supply less elastic because producers cannot quickly expand output. In the long run, all inputs are variable, and new firms can enter or exit, making supply more elastic. The distinction between short- and long-run supply will appear again in cost curves and competitive market equilibrium.
Understanding elasticity of supply helps explain why industries like agriculture may have steep supply curves in the short run (because crops cannot be grown faster), but flatter supply curves in the long run (because more land or technology can be used). On AP exams, always specify the time frame if the question involves responsiveness. This habit demonstrates attention to detail.

Market Equilibrium (Including Disequilibrium)

Definition of Market Equilibrium

Market equilibrium occurs when the quantity demanded by consumers equals the quantity supplied by producers at a specific price. This point is where the demand curve and the supply curve intersect, and it determines the equilibrium price $P_e$ and equilibrium quantity $Q_e$. At this price, there is no tendency for the market to change because buyers and sellers are satisfied with their choices. This balance is central to how competitive markets allocate scarce resources efficiently.
Equilibrium reflects both consumer preferences and producer costs simultaneously. It ensures that goods go to the consumers who value them most (willing to pay at least $P_e$) and are produced by the firms that can supply them at the lowest cost (willing to sell at most $P_e$). This dual alignment of willingness to pay and willingness to sell is what makes equilibrium efficient in competitive markets. Understanding this logic prepares you for later topics like welfare analysis and deadweight loss.
On a graph, equilibrium is easy to identify as the crossing point of demand and supply. Label this point clearly with $P_e$ and $Q_e$. Always remember that any shifts in supply or demand will move this intersection, leading to new equilibrium outcomes. This dynamic adjustment is the core of comparative statics analysis.

Surplus and Shortage (Disequilibrium)

When the price is set above equilibrium, quantity supplied exceeds quantity demanded, creating a surplus. Producers want to sell more than consumers are willing to buy, so unsold goods pile up. In a free market, this surplus puts downward pressure on prices as sellers compete to clear excess inventory. The process continues until the market returns to equilibrium at $P_e$.
When the price is set below equilibrium, quantity demanded exceeds quantity supplied, creating a shortage. Consumers want to buy more than firms are willing to sell, which leads to long lines, waiting lists, or rationing. In a free market, the shortage bids up prices as consumers compete for limited goods, pushing the market back to equilibrium. This self-correcting mechanism explains why competitive markets tend toward balance over time.
Disequilibrium can persist if outside forces prevent prices from adjusting. Price ceilings (like rent controls) lock the market below equilibrium, keeping shortages in place. Price floors (like minimum wages) lock the market above equilibrium, keeping surpluses in place. This introduces inefficiency and sets the stage for policy analysis in later sections.

Changes in Equilibrium: Shifts in Demand or Supply

A rightward shift of demand (increase in demand) leads to a higher equilibrium price and quantity, while a leftward shift (decrease) lowers both. This reflects changes in consumer preferences, income, or the prices of related goods. Always specify both the direction of the shift and the resulting changes in equilibrium price and quantity in your explanation. Clear diagrams are essential here.
A rightward shift of supply (increase in supply) lowers the equilibrium price and raises equilibrium quantity. A leftward shift (decrease in supply) raises the equilibrium price and lowers equilibrium quantity. These shifts capture changes in input costs, technology, or the number of producers. Connecting supply shifts to cost conditions strengthens your answers.
When both curves shift at once (a “double shift”), the direction of one variable (price or quantity) is indeterminate without further information. For example, if demand rises and supply falls, equilibrium price definitely rises, but the effect on quantity depends on the relative size of the shifts. These problems require careful logic and labeling on AP exams.

The Role of Prices in Market Adjustment

Prices act as signals and incentives in markets. A high price signals producers to supply more and consumers to demand less, while a low price signals the opposite. These adjustments move the market toward equilibrium. This “invisible hand” process is a key idea in classical economics and is central to understanding efficient allocation.
In disequilibrium, prices perform the role of correcting imbalances. Surpluses cause prices to fall, shortages cause prices to rise. This automatic adjustment mechanism explains why competitive markets are generally stable. Exceptions occur when government intervention or external constraints prevent prices from changing freely.
Connecting this to Unit 1, the idea of opportunity cost underlies why buyers and sellers adjust to new prices. For consumers, higher prices raise the cost of purchasing, leading to substitution. For producers, higher prices increase the payoff from devoting resources to production. This alignment of costs and benefits through prices links scarcity and efficiency across the curriculum.

Price Elasticity

Price Elasticity of Demand (PED)

Price elasticity of demand measures how responsive the quantity demanded is to a change in the good’s own price. The formula is \[ E_d = \frac{\%\;\Delta Q_d}{\%\;\Delta P} \] where $ \%\;\Delta Q_d $ is the percentage change in quantity demanded and $ \%\;\Delta P $ is the percentage change in price. PED is always negative due to the law of demand, but we report it as an absolute value for simplicity. The more elastic demand is, the more sensitive consumers are to price changes.
If $E_d > 1$, demand is elastic (quantity responds strongly), if $E_d = 1$, it is unit elastic, and if $E_d < 1$, it is inelastic (quantity responds weakly). For example, luxury goods or goods with many substitutes often have elastic demand, while necessities like insulin have inelastic demand. Elasticity explains why total revenue moves in opposite directions depending on the elasticity of demand when price changes. On AP exams, clearly identify both the numerical classification and the reasoning behind it.
Determinants of demand elasticity include availability of substitutes, proportion of income spent on the good, whether the good is a necessity or luxury, and the time horizon. In the short run, demand is usually more inelastic because consumers need time to adjust, while in the long run, they can find alternatives, making demand more elastic. Always link the concept back to consumer behavior and opportunity cost. Diagrams can also help show elasticity by comparing the steepness of demand curves.

Price Elasticity of Supply (PES)

Price elasticity of supply measures how responsive quantity supplied is to a change in price. The formula is \[ E_s = \frac{\%\;\Delta Q_s}{\%\;\Delta P}. \] Supply is usually positively related to price, so $E_s$ is nonnegative. A higher elasticity means producers can respond quickly and easily to price changes.
Elastic supply ($E_s > 1$) means firms can significantly increase output when prices rise, while inelastic supply ($E_s < 1$) means output cannot change much. For instance, agricultural goods are often inelastic in the short run because crops cannot be grown faster, but more elastic in the long run as farmers can plant more land. Manufactured goods with flexible inputs tend to have higher supply elasticity. This highlights the importance of the time horizon in both demand and supply elasticity.
Key determinants of supply elasticity include the flexibility of production processes, availability of spare capacity, ease of storing inventory, and the time period under consideration. When producers can quickly shift resources or use unused capacity, supply is more elastic. If production requires specialized resources, supply tends to be inelastic. Recognizing these conditions allows you to predict how industries react to policy changes like subsidies or taxes.

Cross-Price Elasticity of Demand (XED)

Cross-price elasticity measures how the quantity demanded of one good responds to a price change of another good. The formula is \[ E_{xy} = \frac{\%\;\Delta Q_x}{\%\;\Delta P_y}. \] It captures whether goods are substitutes, complements, or unrelated. This elasticity connects directly to the concepts of related goods introduced in demand analysis.
If $E_{xy} > 0$, the goods are substitutes, because a higher price of $Y$ makes consumers switch to $X$. If $E_{xy} < 0$, the goods are complements, since a higher price of $Y$ reduces demand for $X$. If $E_{xy} = 0$, the goods are unrelated. AP questions often require you to interpret the sign of the elasticity, not just compute the number.
Cross-price elasticity helps firms and policymakers understand how markets interact. For example, if gasoline prices rise, demand for electric cars might increase (positive XED), while demand for SUVs might decrease (negative XED with gasoline). This tool allows economists to anticipate ripple effects across markets. Making these connections is critical for full-credit explanations.

Income Elasticity of Demand (YED)

Income elasticity of demand measures how the quantity demanded of a good responds to a change in consumer income. The formula is \[ E_y = \frac{\%\;\Delta Q_d}{\%\;\Delta Y}. \] It classifies goods as normal or inferior based on the sign and size of the elasticity. YED is essential for understanding how macroeconomic changes affect micro-level markets.
If $E_y > 0$, the good is normal (demand rises with income). If $E_y < 0$, the good is inferior (demand falls as income rises). Within normal goods, necessities typically have $0 < E_y < 1$ (demand rises less than proportionally), while luxuries have $E_y > 1$ (demand rises more than proportionally). These distinctions connect back to Unit 1’s discussion of normal and inferior goods.
For example, as incomes increase, demand for restaurant meals rises (positive, possibly >1), while demand for instant noodles may fall (negative). Income elasticity helps predict how industries grow or shrink with economic development. Governments also use YED to anticipate which goods will expand tax bases in growing economies. On exams, always connect the elasticity classification to real-world examples.

Consumer and Producer Surplus

Consumer Surplus

Consumer surplus is the difference between the maximum price a buyer is willing to pay for a good and the actual price paid. It measures the extra benefit consumers receive by paying less than what they were willing to pay. Graphically, it is the area below the demand curve and above the market price, up to the equilibrium quantity. This captures the concept that consumers often get more value from a purchase than the dollar cost alone reflects.
For example, if a buyer is willing to pay \$10 for a coffee but only has to pay \$6, their consumer surplus is \$4. Aggregated across all buyers in the market, consumer surplus measures total consumer welfare. As prices fall, consumer surplus expands because the price line moves downward, increasing the triangular area between the demand curve and price. This illustrates how lower prices benefit consumers directly through increased welfare.
Consumer surplus is reduced when prices rise, when demand shifts leftward, or when government interventions like taxes or price floors raise the effective price. Understanding how policies alter consumer surplus is key for welfare analysis. On AP exams, always identify the area on the graph and explain why it increases or decreases.

Producer Surplus

Producer surplus is the difference between the actual price received by sellers and the minimum price at which they are willing to sell. It represents the extra benefit producers receive by selling at market price rather than their cost of production. Graphically, it is the area above the supply curve and below the market price, up to the equilibrium quantity. This measures the net welfare producers gain from participating in the market.
For example, if a firm is willing to sell a unit of output for \$3 but the market price is \$7, their producer surplus for that unit is \$4. Aggregated across all producers, this area represents total producer welfare. As prices rise, producer surplus expands because the price line moves upward, increasing the triangular area between the price and supply curve. This demonstrates why higher market prices benefit producers.
Producer surplus decreases when prices fall, when supply shifts leftward, or when government interventions like price ceilings or taxes reduce the effective price received. Just like consumer surplus, producer surplus is crucial for evaluating policy impacts. On exam diagrams, shade this area clearly and label it properly to avoid confusion.

Total Surplus and Market Efficiency

Total surplus is the sum of consumer surplus and producer surplus, representing the overall welfare created by the market. At equilibrium, total surplus is maximized because the allocation of goods is efficient. All units with a marginal benefit greater than marginal cost are produced and consumed, and no units with marginal cost greater than marginal benefit are wasted. This ensures resources are allocated to their highest-valued use.
When markets are in disequilibrium, total surplus is not maximized. Surpluses and shortages prevent efficient trades from happening, leaving potential gains unrealized. Government interventions such as taxes, subsidies, or price controls can reduce total surplus by introducing deadweight loss. This loss represents the welfare that disappears because mutually beneficial trades no longer occur.
Connecting this to Unit 1, the efficiency of equilibrium ties back to cost-benefit analysis and marginal thinking. The equilibrium point ensures $ MB = MC $ at the market level, maximizing net benefits. This connection shows why equilibrium is not just balance, but also efficiency. On AP exams, you should always explain both the distribution of surplus and the efficiency implications.

Market Interventions (Ceilings, Floors, Taxes, Subsidies, and Deadweight Loss)

Price Ceilings

A price ceiling is a legal maximum price set below the equilibrium price to make goods more affordable. Examples include rent controls or caps on gasoline prices. Because the ceiling is below equilibrium, quantity demanded exceeds quantity supplied, creating a shortage. This shortage often leads to rationing, long lines, black markets, or declines in product quality.
Graphically, the ceiling is drawn as a horizontal line below $P_e$. Consumer surplus can increase for those who buy at the lower price, but many consumers are unable to find the product, reducing overall welfare. Producer surplus falls significantly because sellers receive less revenue and produce less. Total surplus declines, creating deadweight loss.
While intended to help consumers, price ceilings can harm them in the long run. Shortages reduce availability, discourage investment in production, and may lower quality. This shows the trade-off between equity (affordability) and efficiency (maximized surplus) that policymakers face. On exams, always explain who benefits and who is harmed.

Price Floors

A price floor is a legal minimum price set above equilibrium to protect producers’ incomes. Examples include minimum wages in labor markets or agricultural price supports. Because the floor is above equilibrium, quantity supplied exceeds quantity demanded, creating a surplus. In labor markets, this manifests as unemployment when labor supplied is greater than labor demanded.
Graphically, the floor is drawn as a horizontal line above $P_e$. Producers may gain from higher prices on units sold, but many cannot sell their full output, leaving unsold surpluses. Consumer surplus falls due to higher prices, while producer surplus may rise or fall depending on whether unsold output is costly. Deadweight loss results from trades that would have occurred at equilibrium but no longer happen.
Government sometimes buys up surpluses (like agricultural goods) to support prices, but this requires taxpayer funding. Alternatively, unsold goods may go to waste, which is inefficient. This intervention highlights the tension between protecting producer welfare and maintaining market efficiency. AP exam questions often test this in the context of labor or farming examples.

Taxes

A per-unit tax is a fixed amount levied on each unit sold, shifting the supply curve upward by the tax amount. Taxes raise the equilibrium price buyers pay, lower the equilibrium price sellers receive, and reduce the equilibrium quantity. The wedge between consumer price and producer price equals the tax. This reduces both consumer surplus and producer surplus.
The incidence (burden) of the tax depends on elasticity. When demand is inelastic, consumers bear more of the tax; when supply is inelastic, producers bear more of it. The side of the market that is less elastic carries the greater burden. On exams, always mention elasticity when explaining tax incidence.
Taxes create deadweight loss because mutually beneficial trades between buyers and sellers that would have happened at equilibrium no longer occur. Government collects tax revenue (a rectangle between buyer and seller prices up to quantity sold), but total surplus falls by the size of the deadweight loss triangle. This shows how taxation reduces efficiency even if it raises revenue.

Subsidies

A per-unit subsidy is a fixed amount given to producers for each unit sold, shifting the supply curve downward by the subsidy amount. This lowers the effective price for buyers and raises the effective revenue for sellers. As a result, equilibrium quantity rises, consumer surplus and producer surplus both expand, and government expenditure increases.
Subsidies encourage overproduction compared to the efficient equilibrium. While they may support socially desirable goods (like renewable energy or education), they also create deadweight loss because resources are used for goods valued less than their cost of production. The deadweight loss triangle reflects wasted resources from producing beyond the efficient level.
The incidence of subsidies, like taxes, depends on elasticity. The side of the market that is less elastic captures more of the subsidy benefit. Policymakers must weigh the trade-off between encouraging certain industries and the inefficiency that results. This ties into public policy debates about fairness and efficiency.

Deadweight Loss (DWL)

Deadweight loss is the loss of total surplus that occurs when a market intervention prevents some mutually beneficial trades. It appears as the triangular area between supply and demand curves that represents “missed transactions.” DWL shows up in price ceilings (because some trades cannot occur due to shortages), price floors (because surpluses prevent trades), taxes (because higher prices discourage buyers), and subsidies (because they promote inefficient trades).
The size of DWL depends on elasticity. With highly elastic demand or supply, quantity responds strongly to price changes, creating larger DWL. With inelastic demand or supply, DWL is smaller because fewer trades are distorted. On AP exams, clearly identify DWL as “the value of lost trades that would have increased total surplus.”
DWL connects to efficiency: in equilibrium without intervention, total surplus is maximized, and DWL is zero. Any intervention that drives a wedge between buyer and seller prices reduces efficiency unless it corrects a market failure (like externalities). This prepares you for deeper welfare analysis later in the course.

The Effects of Government Intervention in Markets

Policy Motivations and Goals

Governments intervene in markets for many reasons, including promoting fairness, stabilizing the economy, correcting market failures, and protecting vulnerable groups. Policies such as price controls, taxes, subsidies, tariffs, and regulations are designed to achieve social or political objectives. For example, rent control is meant to protect tenants, while agricultural supports help stabilize farmers’ incomes. Each intervention reflects trade-offs between efficiency (maximizing total surplus) and equity (fairness in outcomes).
Market outcomes without intervention maximize efficiency under competitive conditions but can lead to inequality or socially undesirable allocations. Governments may therefore prioritize equity even if efficiency falls. Recognizing this trade-off is crucial to understanding why interventions persist despite their costs. On AP exams, explicitly state both the intended goal of the policy and the unintended side effects.

Efficiency Implications

Efficiency refers to maximizing total surplus (consumer + producer surplus) with no deadweight loss. Market interventions often reduce efficiency by preventing mutually beneficial trades. For instance, a price ceiling creates shortages and rationing, while a price floor creates surpluses and waste. Taxes shrink consumer and producer surplus while generating deadweight loss, even though they raise government revenue.
Some interventions may improve efficiency when markets fail. For example, correcting negative externalities with a tax aligns private and social costs, eliminating overproduction. Similarly, subsidies for education or vaccines can address positive externalities by encouraging more socially beneficial consumption. These cases illustrate that intervention can sometimes enhance efficiency, but only if well-designed.

Equity Implications

Equity concerns fairness and the distribution of economic benefits. Interventions often prioritize equity by redistributing welfare between consumers and producers. Price ceilings may help low-income renters, while minimum wages raise earnings for workers who keep jobs. These outcomes show how interventions can redistribute surplus to favored groups.
However, redistribution often comes with costs. Rent control may benefit tenants who find apartments but harm those who cannot due to shortages. Minimum wages may help some workers earn more but lead others to unemployment. Policymakers must weigh whether the equity gains justify the efficiency losses. On exams, always discuss both sides.

Short-Run vs. Long-Run Effects

In the short run, interventions may seem beneficial because they deliver immediate relief. For example, a price ceiling lowers costs for current renters. However, in the long run, interventions often reduce investment and supply, worsening the original problem. Housing shortages under rent control and labor market distortions under minimum wages illustrate these unintended consequences.
Elasticity plays a key role in determining long-run effects. The more elastic supply and demand are, the greater the distortions and deadweight loss over time. This is why interventions that look small in the short run can have much larger costs in the long run. Always mention time horizons in your explanations for full credit.

Balancing Efficiency and Equity

Policymakers must balance efficiency and equity when designing interventions. Efficiency ensures maximum total surplus, while equity ensures fair distribution. Rarely can both be maximized at the same time. Trade-offs are therefore unavoidable in public policy.
Some interventions attempt to minimize efficiency losses while improving equity. For instance, lump-sum transfers redistribute income without distorting prices. Targeted subsidies (like food stamps) help specific groups while leaving most of the market unaffected. These tools reflect efforts to align fairness with economic incentives. On exams, identify when a policy primarily addresses efficiency, equity, or both.

International Trade and Public Policy

Gains from Trade

International trade allows countries to specialize according to comparative advantage, producing goods at lower opportunity costs and trading for what they produce less efficiently. This increases total world output and raises living standards. Consumers gain access to a wider variety of goods at lower prices, while producers access larger markets. These gains mirror the logic of specialization and exchange introduced in Unit 1, but at the global scale.
Trade creates winners and losers: export industries expand and benefit, while import-competing industries may shrink. For example, U.S. farmers benefit from selling crops abroad, but U.S. textile workers may suffer job losses due to cheaper imports. Policymakers must weigh overall efficiency gains against distributional equity effects. On AP exams, always mention both total gains and redistribution.

Tariffs and Quotas

A tariff is a tax on imports that raises the price of foreign goods, reducing the quantity imported. This benefits domestic producers (who face less competition) and raises government revenue, but it harms consumers through higher prices and creates deadweight loss. Graphically, tariffs shrink consumer surplus, increase producer surplus, and generate government revenue, but total surplus falls. This tradeoff is central to policy debates.
A quota sets a maximum quantity of imports. It has effects similar to a tariff: consumers pay higher prices, producers benefit, and deadweight loss arises. Unlike tariffs, quotas do not generate tax revenue, but the “quota rents” (profits from selling limited imports at high prices) may go to foreign exporters or domestic license holders. Quotas therefore redistribute welfare differently than tariffs, but both reduce efficiency compared to free trade.

Free Trade vs. Protectionism

Free trade maximizes efficiency by letting comparative advantage determine production patterns. Consumers enjoy lower prices and greater variety, while total surplus increases. However, domestic industries exposed to global competition may contract, leading to job losses and political backlash. This explains the tension between efficiency and equity in trade policy.
Protectionism uses tools like tariffs, quotas, and subsidies to shield domestic industries. While it protects jobs and incomes in certain sectors, it raises costs for consumers and introduces deadweight loss. Protectionist policies may also invite retaliation from other countries, reducing trade overall. The equity benefits for some groups come at the cost of global efficiency.

Trade and Surplus Analysis

With free trade, the domestic price equals the world price, which is usually lower than the autarky (no trade) price. Consumers gain surplus from lower prices, while domestic producers lose some surplus because they sell less at a lower price. Total surplus rises because consumer gains outweigh producer losses, creating net welfare gains. Graphically, this shows up as an expansion of consumer surplus and overall efficiency.
When tariffs or quotas are imposed, part of consumer surplus is transferred to producers or government (in the case of tariffs), but some surplus disappears entirely as deadweight loss. This area of lost welfare represents transactions that would have occurred under free trade but no longer happen due to the policy. Identifying these triangles on a graph is a standard AP Micro skill. Always show which groups gain, lose, and how efficiency is affected.

Public Policy Implications

Trade policy reflects the same efficiency-equity trade-offs seen in domestic market interventions. Free trade is efficient but can be inequitable for workers in import-competing industries. Protectionism can improve equity for some groups but sacrifices efficiency. Policymakers often compromise between the two, balancing political and economic pressures.
Governments sometimes justify protectionism using arguments such as the “infant industry” argument (young industries need time to develop), national security concerns, or preventing dumping (selling goods below cost). While these arguments may have merit in limited cases, they are often misused to justify inefficient policies. On AP exams, you should be able to evaluate these arguments critically and connect them to efficiency and equity concepts.