The Law of Supply and Demand
The supply and demand model is the most fundamental framework in economics, first formalized by Alfred Marshall in 1890. The demand curve slopes downward — as price rises, consumers buy less. The supply curve slopes upward — as price rises, producers supply more. Where these curves intersect, the market clears: quantity demanded equals quantity supplied.
Finding Equilibrium
In this linear model, demand is Q_d = a - b·P and supply is Q_s = c + d·P. Setting them equal gives the equilibrium price P* = (a-c)/(b+d) and quantity Q* = (a·d+b·c)/(b+d). The parameters a and c represent intercepts (base demand and supply), while b and d represent slopes (price sensitivity). Steeper slopes mean less elastic responses to price changes.
Surplus and Welfare
Consumer surplus (the blue area above the price line and below demand) represents the benefit consumers get from paying less than their maximum willingness to pay. Producer surplus (the green area below the price line and above supply) represents profit above the minimum price producers would accept. Together, they measure total economic welfare.
The Effect of Taxation
When a per-unit tax is imposed, the supply curve shifts upward by the tax amount. The new equilibrium has a higher buyer price, lower seller price, and reduced quantity. The deadweight loss triangle — the red shaded area — represents trades that no longer occur. This welfare loss goes to no one: not buyers, not sellers, not the government. It is a pure inefficiency, and it grows with the square of the tax rate, explaining why economists generally prefer broad-based, low-rate taxes.