Definition of market equilibrium

Allocation of Resources – Price Determination

Learning Objectives

• Explain the basic economic problem and the factors of production.
• Define demand and supply (individual and market) and illustrate the law of demand and the law of supply.
• Describe how the price mechanism allocates resources and how market equilibrium is reached.
• Analyse the effect of shifts in demand or supply on equilibrium price and quantity.
• Calculate and interpret price elasticity of demand (PED) and price elasticity of supply (PES).
• Identify the characteristics of a market economy, recognise different forms of market failure and describe a mixed economic system.
• Link the concepts of price determination to the next unit on Money and Banking.

1. The Basic Economic Problem

Resources are scarce, so societies must decide:

• What goods and services to produce?
• How to produce them?
• For whom to produce them?

These three allocation questions are answered by the factors of production:

Factor	Definition	Reward
Land	Natural resources (e.g., minerals, farmland)	Rent
Labour	Human effort – physical and mental	Wages
Capital	Man‑made goods used to produce other goods (machinery, buildings)	Interest
Enterprise	Risk‑taking and organisational ability	Profit

Choosing between alternative uses of scarce resources creates opportunity cost – the value of the next best alternative foregone.

A simple way to visualise scarcity, choice and opportunity cost is the Production Possibility Curve (PPC). The curve shows the maximum combinations of two goods that an economy can produce when all resources are fully and efficiently employed.

2. The Price Mechanism

The price mechanism is the process by which the forces of supply and demand interact to answer the three basic economic questions. Prices act as signals:

• For consumers – indicating how much a good is worth to others.
• For producers – indicating how much profit can be earned.

Through these signals, scarce resources are allocated efficiently without central direction.

3. Demand and Supply Fundamentals

Demand

• Individual demand: Quantity of a good that one consumer is willing and able to buy at each price.
• Market demand: Horizontal summation of all individual demand schedules.

Law of Demand: Ceteris paribus, as price falls, the quantity demanded rises (downward‑sloping demand curve).

Determinants of demand (shift factors):

Determinant	Effect on Demand
Income	Higher income → demand for normal goods rises; for inferior goods falls.
Prices of related goods	Substitutes: price rise → demand rises. Complements: price rise → demand falls.
Tastes & preferences	More favourable → demand rises.
Expectations	Future price rise expected → current demand rises.
Number of buyers	More buyers → demand rises.

Supply

• Individual supply: Quantity of a good that one producer is willing and able to sell at each price.
• Market supply: Horizontal summation of all individual supply schedules.

Law of Supply: Ceteris paribus, as price rises, the quantity supplied rises (upward‑sloping supply curve).

Determinants of supply (shift factors):

Determinant	Effect on Supply
Input prices	Higher input costs → supply falls.
Technology	Improved technology → supply rises.
Number of sellers	More sellers → supply rises.
Expectations	Future price fall expected → current supply falls.
Taxes & subsidies	Tax ↑ → supply falls; subsidy ↑ → supply rises.

Basic Demand‑Supply Diagram

4. Market Equilibrium

Definition

Market equilibrium occurs when the quantity demanded equals the quantity supplied at a particular price. At this point there is no tendency for the price to change because the amount buyers want to purchase exactly matches the amount sellers want to sell.

Mathematically: \(Q_d = Q_s\)

How Equilibrium is Reached

1. Price above equilibrium: Quantity supplied > quantity demanded → surplus.
2. Producers lower price to clear excess stock.
3. Price below equilibrium: Quantity demanded > quantity supplied → shortage.
4. Consumers compete for the limited goods, pushing price up.
5. The price adjusts until Qₑ = Qₑ; the market is then in equilibrium.

Characteristics of Equilibrium

Feature	Explanation
Stable price	The price tends to remain constant unless an external factor shifts demand or supply.
Efficient allocation	Resources are allocated where they are most valued; there is no excess or unmet demand.
No surplus or shortage	Quantity supplied equals quantity demanded.

Example Calculation

Demand: \(Q_d = 120 - 2P\)
Supply: \(Q_s = 20 + 3P\)

Set \(Q_d = Q_s\):

\(120 - 2P = 20 + 3P \;\Rightarrow\; 100 = 5P \;\Rightarrow\; P_e = 20\)

Substitute \(P_e\) into either equation:

\(Q_e = 20 + 3(20) = 80\)

Thus, equilibrium price = £20 and equilibrium quantity = 80 units.

5. Shifts in Demand or Supply – Price Changes

When either the demand curve or the supply curve shifts, the equilibrium price and quantity change. The direction of the shift determines whether the price rises or falls.

Shift	Effect on Price	Effect on Quantity	Diagrammatic Change
Demand ↑ (right‑ward)	Price ↑	Quantity ↑	New demand curve D₂ to the right of D₁
Demand ↓ (left‑ward)	Price ↓	Quantity ↓	New demand curve D₂ to the left of D₁
Supply ↑ (right‑ward)	Price ↓	Quantity ↑	New supply curve S₂ to the right of S₁
Supply ↓ (left‑ward)	Price ↑	Quantity ↓	New supply curve S₂ to the left of S₁

Illustrative Example

Suppose consumer income rises, shifting demand from D₁ to D₂. The new equilibrium (E₂) has a higher price (P₂) and a higher quantity (Q₂) than the original equilibrium (E₁).

6. Price Elasticity of Demand (PED)

Definition & Formula

PED measures the responsiveness of quantity demanded to a change in price.

\(\displaystyle \text{PED} = \frac{\%\;\text{change in } Q_d}{\%\;\text{change in } P}\)

Interpretation of Values

• Perfectly inelastic (PED = 0): Quantity demanded does not change as price changes (e.g., life‑saving medication).
• Inelastic (0 < |PED| < 1): Quantity changes proportionally less than price.
• Unitary elastic (|PED| = 1): Percentage change in quantity equals percentage change in price.
• Elastic (|PED| > 1): Quantity changes proportionally more than price.
• Perfectly elastic (PED → ∞): Any price increase eliminates all demand.

Determinants of PED

Determinant	Effect on Elasticity
Availability of close substitutes	More substitutes → more elastic.
Proportion of income spent on the good	Higher proportion → more elastic.
Nature of the good (luxury vs. necessity)	Luxury goods → more elastic.
Time horizon	Longer period → more elastic.

Calculation Example

Price falls from £10 to £8 and quantity demanded rises from 150 to 210 units.

\[ \text{PED} = \frac{(210-150)/150}{(8-10)/10} = \frac{0.40}{-0.20} = -2.0 \]

Absolute value = 2.0 → demand is elastic.

7. Price Elasticity of Supply (PES)

Definition & Formula

PES measures the responsiveness of quantity supplied to a change in price.

\(\displaystyle \text{PES} = \frac{\%\;\text{change in } Q_s}{\%\;\text{change in } P}\)

Interpretation of Values

• Perfectly inelastic (PES = 0): Quantity supplied does not change with price (e.g., fixed‑supply land).
• Inelastic (0 < PES < 1): Quantity changes proportionally less than price.
• Unitary elastic (PES = 1): Percentage change in quantity equals percentage change in price.
• Elastic (PES > 1): Quantity changes proportionally more than price.
• Perfectly elastic (PES → ∞): Any price drop reduces supply to zero.

Determinants of PES

Determinant	Effect on Elasticity
Time period for production	Longer time → more elastic.
Availability of spare capacity	More spare capacity → more elastic.
Mobility of factors of production	Highly mobile factors → more elastic.
Complexity of the production process	More complex → less elastic.

Calculation Example

Price rises from £5 to £6 and quantity supplied rises from 200 to 260 units.

\[ \text{PES} = \frac{(260-200)/200}{(6-5)/5} = \frac{0.30}{0.20} = 1.5 \]

PES > 1 → supply is elastic.

8. Market Economic System

A market (or free‑market) economy is one in which most decisions about what to produce, how to produce it, and for whom it is produced are made by households and firms interacting in markets.

Advantages	Disadvantages
Efficient allocation of resources through the price mechanism. Consumer sovereignty – choices reflect consumer preferences. Innovation and entrepreneurship driven by profit motive.	Potential for income and wealth inequality. Undersupply of merit goods (education, health) and oversupply of demerit goods (tobacco, alcohol). Market failures (public goods, externalities, monopoly).

9. Market Failure

Market failure occurs when the free market does not allocate resources efficiently, resulting in a net loss of welfare.

• Public goods – non‑rival and non‑excludable (e.g., street lighting).
• Externalities – costs or benefits that affect third parties (e.g., pollution, vaccination).
• Merit and demerit goods – goods that are under‑ or over‑consumed relative to society’s optimum.
• Monopoly power – a single seller can restrict output and raise price.

10. Mixed Economic System

A mixed economy combines elements of both market and planned economies. The government intervenes to correct market failures, provide public goods, and achieve social objectives.

Key Features	Typical Government Interventions
Private ownership co‑exists with public ownership. Markets allocate most goods, but the state regulates where necessary.	Taxes and subsidies to influence prices and output. Regulation (e.g., safety standards, environmental limits). Provision of public goods (education, defence, health).

11. Linking On – Money & Banking

Understanding how prices are determined provides the foundation for the next unit on Money and Banking. In that unit you will explore how the financial system influences aggregate demand, interest rates, and the overall level of economic activity.