Drawing and interpretation of disequilibrium using demand and supply curves

IGCSE Economics (0455) – Price Determination, Allocation of Resources & Macro‑Economic Context

Learning Objectives

• Explain scarcity, the three fundamental allocation questions and the distinction between economic and free goods.
• Identify the factors of production and the four factor‑reward incomes (rent, wages, interest, profit).
• Draw and interpret demand and supply curves, locate market equilibrium and illustrate disequilibrium (surplus / shortage).
• Analyse how market forces move a market back towards equilibrium and evaluate the impact of government intervention.
• Calculate and interpret price elasticity of demand (PED) and price elasticity of supply (PES) using the midpoint method.
• Describe the main types of market systems (pure market, mixed, command) and the role of the government.
• Recognise common forms of market failure (public goods, merit/demerit goods, externalities, monopoly) and illustrate them with simple diagrams.
• Understand macro‑economic indicators (GDP, inflation, unemployment) and the tools of fiscal and monetary policy.
• Explain the basics of economic development, international trade, balance of payments and exchange rates.
• Identify the main micro‑economic decision‑makers (households, firms, workers, government, banks) and the markets in which they operate.
• Apply the above concepts to exam‑style questions, including evaluation of advantages and disadvantages.

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1. The Basic Economic Problem

1.1 Scarcity and Allocation

• Scarcity: Unlimited wants but limited resources.
• Three allocation questions:
  1. What to produce? (choice of goods & services)
  2. How to produce? (choice of techniques & factor combinations)
  3. For whom to produce? (distribution of output)

1.2 Economic vs Free Goods

• Economic goods: Have a price because they are scarce (e.g., a smartphone).
• Free goods: Abundant and available at zero price (e.g., air, sunlight).

1.3 Factors of Production & Factor Rewards

Factor	Reward (Income)
Land (natural resources)	Rent
Labour (human effort)	Wages
Capital (machinery, buildings)	Interest
Enterprise (risk‑taking, organisation)	Profit

1.4 Production Possibility Curve (PPC)

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2. Allocation of Resources – Demand, Supply & Price Mechanism

2.1 Demand

• Definition: Quantity of a good that consumers are willing and able to buy at each possible price, ceteris paribus.
• Law of demand: Inverse relationship between price (P) and quantity demanded (Q_d).
• Demand curve: Downward‑sloping; Price on the vertical axis, Quantity on the horizontal axis.
• Determinants (shift factors): Income, tastes & preferences, price of related goods (substitutes & complements), expectations, number of buyers.

2.2 Supply

• Definition: Quantity of a good that producers are willing and able to sell at each possible price, ceteris paribus.
• Law of supply: Direct relationship between price (P) and quantity supplied (Q_s).
• Supply curve: Upward‑sloping.
• Determinants (shift factors): Input prices, technology, expectations, number of sellers, taxes & subsidies, price of related goods (substitutes in production).

2.3 Market Equilibrium

• Occurs where Q_d = Q_s. The corresponding price is the equilibrium price (P_e) and the quantity is the equilibrium quantity (Q_e).

2.4 Disequilibrium – Surplus and Shortage

How to draw disequilibrium

1. Start with the equilibrium diagram.
2. Surplus (price above P_e)
   • Draw a horizontal line at a price P_high > P_e.
   • Read Q_s from the supply curve and Q_d from the demand curve.
   • The vertical gap (Q_s − Q_d) is the surplus.
3. Shortage (price below P_e)
   • Draw a horizontal line at a price P_low < P_e.
   • Read Q_d and Q_s as above.
   • The vertical gap (Q_d − Q_s) is the shortage.

Interpretation of the gaps

• Surplus: Excess supply puts downward pressure on price. Sellers cut prices → quantity demanded rises and quantity supplied falls until equilibrium is restored.
• Shortage: Excess demand puts upward pressure on price. Buyers are willing to pay more → price rises → quantity demanded falls and quantity supplied rises, moving back to equilibrium.

2.5 Price Elasticity

Definitions & Terminology

• Price Elasticity of Demand (PED): % change in quantity demanded ÷ % change in price.
• Price Elasticity of Supply (PES): % change in quantity supplied ÷ % change in price.
• When |E| > 1 → elastic; |E| = 1 → unit‑elastic; |E| < 1 → inelastic; E = 0 → perfectly inelastic; E = ∞ → perfectly elastic.

Mid‑point (arc) formula

\[ \text{PED} \;=\; \frac{\displaystyle \frac{Q_2-Q_1}{(Q_1+Q_2)/2}}{\displaystyle \frac{P_2-P_1}{(P_1+P_2)/2}} \qquad\qquad \text{PES} \;=\; \frac{\displaystyle \frac{Q_2-Q_1}{(Q_1+Q_2)/2}}{\displaystyle \frac{P_2-P_1}{(P_1+P_2)/2}} \]

Interpretation table

Elasticity	Interpretation	Typical examples
|E| > 1	Elastic – quantity responds strongly to price changes.	Luxury goods, many close substitutes.
|E| = 1	Unit‑elastic.	Some commodities in the short‑run.
|E| < 1	Inelastic – quantity responds weakly.	Necessities, few substitutes.
E = 0	Perfectly inelastic – quantity does not change (vertical demand).	Life‑saving medicine with no alternatives.
E = ∞	Perfectly elastic – any price rise eliminates demand (horizontal demand).	Perfectly competitive commodity with many sellers.

Determinants of PED

• Availability of close substitutes.
• Proportion of income spent on the good.
• Nature of the good (luxury vs. necessity).
• Time horizon (short‑run vs. long‑run).

Determinants of PES

• Flexibility of production techniques.
• Availability of inputs.
• Time horizon (capacity constraints in the short‑run).
• Mobility of factors of production.

2.6 Market Systems & Government Intervention

Types of economic system (Cambridge focus)

System	Key Features	Typical role of government
Pure market (perfect competition)	Decisions made by households & firms via the price mechanism.	Limited – enforce property rights & competition law.
Command	Central authority decides what, how & for whom to produce.	Extensive – planning, price setting, resource allocation.
Mixed	Combination of market forces and state control.	Intervention to correct market failure, redistribute income, provide public goods.

Government tools (Cambridge emphasis)

• Price ceiling: Maximum legal price (e.g., rent control). Set below P_e → shortage; can lead to black‑markets.
• Price floor: Minimum legal price (e.g., minimum wage, agricultural price support). Set above P_e → surplus; may require storage or waste.
• Tax (excise, sales, import): Shifts supply left (or demand left for a consumption tax). Creates dead‑weight loss (inefficiency).
• Subsidy: Shifts supply right (or demand right for a demand‑side subsidy). Can cause over‑consumption and fiscal cost.
• Regulation: Sets standards (safety, environmental). May raise production costs → left‑shift of supply.
• Privatisation / Nationalisation: Transfer of ownership between private sector and state.
• Quotas: Limit the quantity that can be produced or imported – vertical restriction on supply.

Evaluation checklist for any intervention

• Intended economic objective (e.g., reduce shortage, protect consumers).
• Short‑run vs. long‑run effects.
• Impact on efficiency (dead‑weight loss?)
• Distributional consequences (who gains, who loses?).
• Administrative cost and enforceability.
• Potential for unintended consequences (black‑markets, rent‑seeking).

2.7 Market Failure (Brief Overview)

• Public goods: Non‑rival & non‑excludable (e.g., street lighting). Market under‑provides → government provision.
• Merit & demerit goods: Goods the government believes are under‑consumed (merit) or over‑consumed (demerit) relative to society’s optimum (e.g., education, tobacco).
• Externalities:
  • Negative (pollution) – marginal private cost (MPC) < marginal social cost (MSC). Government may impose a Pigouvian tax.
  • Positive (vaccination) – marginal private benefit (MPB) < marginal social benefit (MSB). Government may subsidise.
• Monopoly: Single seller → price above marginal cost, output below efficient level.

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3. Macro‑Economic Context

3.1 Key Macro Indicators

Indicator	What it measures	Typical calculation (simplified)
Gross Domestic Product (GDP)	Total market value of all final goods & services produced in a year.	GDP = C + I + G + (X − M)
Inflation (CPI)	Rate at which the general price level is rising.	Inflation % = [(CPIt − CPIt‑1) / CPIt‑1] × 100
Unemployment rate	Proportion of the labour force that is job‑seeking but without work.	Unemployment % = (Number unemployed / Labour force) × 100

3.2 Fiscal Policy (Government)

• Expansionary fiscal policy: Increase government spending and/or cut taxes → shifts AD right, raises output & employment, may increase inflation.
• Contractionary fiscal policy: Decrease spending and/or raise taxes → shifts AD left, lowers output & inflation.
• Evaluation points: time lag, impact on public debt, distributional effects.

3.3 Monetary Policy (Central bank)

• Expansionary monetary policy: Lower interest rates or increase money supply → reduces cost of borrowing, stimulates investment & consumption.
• Contractionary monetary policy: Raise interest rates or reduce money supply → curbs inflation but may raise unemployment.
• Evaluation points: effectiveness depends on interest‑rate sensitivity, exchange‑rate effects, and time lags.

3.4 Economic Development

• Indicators: GDP per capita, Human Development Index (HDI), life expectancy, literacy rate, access to clean water.
• Barriers to development: Low investment, poor education, inadequate infrastructure, political instability, disease.
• Policies to promote development: Foreign direct investment (FDI), aid, education & health programmes, infrastructure projects, trade liberalisation.

3.5 International Trade

• Comparative advantage: Countries specialise in goods they can produce at a lower opportunity cost.
• Balance of Payments (BoP): Record of all economic transactions with the rest of the world.
  • Current account (trade in goods & services, income, transfers).
  • Capital & financial account (investment flows).
• Exchange rates: Price of one currency in terms of another.
  • Appreciation → imports cheaper, exports more expensive.
  • Depreciation → imports more expensive, exports cheaper.
• Trade protection: Tariffs, quotas, import licences, export subsidies.
  • Intended to protect domestic industries, raise government revenue.
  • Can cause retaliation, higher consumer prices, dead‑weight loss.

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4. Drawing & Interpreting Disequilibrium (Core Skill)

Step‑by‑Step Procedure

1. Draw the standard demand (D) and supply (S) curves and mark the equilibrium point E (P_e, Q_e).
2. Surplus scenario (price above equilibrium):
   • Draw a horizontal line at a price P_high > P_e.
   • Read Q_s on the supply curve and Q_d on the demand curve.
   • Shade the vertical gap (Q_s − Q_d) and label it Surplus.
3. Shortage scenario (price below equilibrium):
   • Draw a horizontal line at a price P_low < P_e.
   • Read Q_d and Q_s as above.
   • Shade the vertical gap (Q_d − Q_s) and label it Shortage.
4. Explain the market‑force adjustment:
   • Surplus → downward pressure on price → movement down the demand curve and up the supply curve.
   • Shortage → upward pressure on price → movement up the demand curve and down the supply curve.

Mathematical Illustration (Linear Functions)

Demand: \(Q_d = a - bP\)  \(b > 0\)

Supply: \(Q_s = c + dP\)  \(d > 0\)

Equilibrium

\[ a - bP_e = c + dP_e \;\Longrightarrow\; P_e = \frac{a - c}{b + d},\qquad Q_e = c + dP_e \]

Excess quantity at any price P

\[ \text{Excess} = Q_s - Q_d = (c - a) + (b + d)P \]

• If \(P > P_e\) → excess > 0 → Surplus.
• If \(P < P_e\) → excess < 0 → Shortage.

Worked Example (Including Elasticities)

Demand: \(Q_d = 200 - 4P\)
Supply: \(Q_s = 20 + 2P\)

1. Find equilibrium

\[ 200 - 4P_e = 20 + 2P_e \;\Longrightarrow\; 180 = 6P_e \;\Longrightarrow\; P_e = 30 \] \[ Q_e = 20 + 2(30) = 80 \]

2. Surplus at a price of £40

• Q_s at £40: \(20 + 2(40) = 100\)
• Q_d at £40: \(200 - 4(40) = 40\)
• Surplus = 100 − 40 = 60 units.

3. Shortage at a price of £20

• Q_s at £20: \(20 + 2(20) = 60\)
• Q_d at £20: \(200 - 4(20) = 120\)
• Shortage = 120 − 60 = 60 units.

4. Elasticities between the two price points (£20 → £40)

\[ \text{PED} = \frac{\frac{120-40}{(120+40)/2}}{\frac{20-40}{(20+40)/2}} = \frac{\frac{80}{80}}{\frac{-20}{30}} = \frac{1}{-0.667} \approx -1.5 \;( \text{elastic} ) \] \[ \text{PES} = \frac{\frac{100-60}{(100+60)/2}}{\frac{40-20}{(40+20)/2}} = \frac{\frac{40}{80}}{\frac{20}{30}} = \frac{0.5}{0.667} \approx 0.75 \;( \text{inelastic} ) \]

Interpretation: Demand is relatively responsive to price changes, whereas supply is less responsive in the short‑run.

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5. Micro‑Economic Decision‑Makers & Market Types

5.1 Decision‑Makers

Agent	Primary Objective	Typical Decisions	Market Interaction
Households	Maximise utility (satisfaction)	What to buy, how much to save, labour supply	Demand side of product markets; supply of labour in factor markets.
Firms	Maximise profit	What to produce, how much, pricing, factor demand	Supply side of product markets; demand for labour, land, capital.
Workers	Earn income & improve skills	Choice of occupation, hours, training	Supply of labour; interaction with firms (wage determination).
Government	Promote welfare, stability & growth	Taxation, spending, regulation, provision of public goods	Both demand and supply sides; can alter market outcomes.
Money & Banking System	Facilitate transactions & control money supply	Set interest rates, provide credit, manage inflation	Influences investment decisions of firms and consumption decisions of households.

5.2 Market Structures (Cambridge focus)

Structure	Key Characteristics	Typical Price‑Setting Power
Perfect competition	Many buyers & sellers, homogeneous product, free entry & exit.	Price‑taker.
Monopolistic competition	Many sellers, differentiated products, some brand loyalty.	Some price‑setting ability.
Oligopoly	Few large firms, inter‑dependent decisions, possible collusion.	Significant price‑setting power.
Monopoly	Single seller, high barriers to entry, unique product.	Price‑maker.

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6. Evaluation & Exam‑Style Tips

6.1 General Evaluation Framework

• State the intended purpose of a policy or market outcome.
• Identify short‑run and long‑run effects.
• Discuss efficiency (dead‑weight loss, consumer/producer surplus).
• Analyse distributional impact (who benefits, who loses?).
• Consider practical constraints (administrative cost, enforcement, time lags).
• Highlight possible unintended consequences (black‑markets, rent‑seeking, crowding‑out).

6.2 Sample Exam Question Blueprint

1. Diagram: Draw a demand‑supply diagram showing equilibrium, then illustrate a price ceiling set below equilibrium. Shade the resulting shortage.
2. Explanation: Describe why the shortage occurs (excess demand) and the market‑force adjustment (price pressure upward).
3. Evaluation: Discuss the advantages (e.g., consumer affordability) and disadvantages (e.g., black‑market, reduced producer surplus, possible quality decline).
4. Link to macro: Explain how a widespread price ceiling could affect inflation and fiscal revenue.

6.3 Quick Recall – Key Formulae

• P_e = (a − c) / (b + d)  (Linear demand = a − bP, supply = c + dP)
• GDP = C + I + G + (X − M)
• Inflation % = [(CPI_t − CPI_t‑1) / CPI_t‑1] × 100
• Unemployment % = (Unemployed / Labour force) × 100
• PED & PES – midpoint formula (see Section 2.5).