Allocation of Resources – Price Determination (0455)
Learning Objective
Students will be able to:
- Explain the basic economic problem and the role of markets in allocating scarce resources.
- Draw and interpret demand and supply curves, distinguish movements from shifts, and calculate market equilibrium.
- Analyse how changes in determinants affect equilibrium price, quantity, consumer expenditure and producer revenue.
- Define and calculate price elasticity of demand (PED) and price elasticity of supply (PES) and use them to predict revenue effects.
- Identify the main micro‑economic decision‑makers, recognise market failures and describe the main features of market and mixed economies.
- Summarise the key macro‑economic tools (fiscal, monetary and supply‑side policies) and their impact on growth, unemployment and inflation.
1. The Basic Economic Problem
1.1 Scarcity and Choice
- Resources are limited but human wants are unlimited → societies must decide what, how and for whom to produce.
- Opportunity cost: the value of the next best alternative foregone when a choice is made.
1.2 Factors of Production and Their Rewards
| Factor | Reward |
|---|
| Land (natural resources) | Rent |
| Labour (human effort) | Wages |
| Capital (machinery, buildings) | Interest |
| Enterprise (entrepreneurship) | Profit |
1.3 Production Possibility Curve (PPC)
A simple PPC shows the maximum combinations of two goods that can be produced with existing resources and technology.
- Points on the curve = efficient production.
- Points inside the curve = under‑utilisation (inefficiency).
- Points outside the curve = unattainable with current resources.
- Outward shift = economic growth (more resources or better technology); inward shift = recession or disaster.
2. Markets – Demand, Supply and Price Determination
2.1 What Is a Market?
A market is any arrangement where buyers and sellers interact to exchange goods or services. It can be physical (e.g., a farmers’ market) or virtual (e.g., an online platform). The price mechanism coordinates the decisions of buyers and sellers.
2.2 The Demand Curve
Shows the relationship between the price of a good (P) and the quantity demanded (Qd).
- Law of demand: As price falls, quantity demanded rises – the curve slopes downwards.
2.2.1 Movements Along the Demand Curve
A change in the price of the good itself causes a movement up or down the same curve.
2.2.2 Shifts of the Demand Curve
Any non‑price factor that changes the quantity demanded at every price shifts the whole curve.
| Determinant | Effect on Demand | Example |
|---|
| Consumer income (normal good) | Rightward shift (increase) | Higher wages → more smartphones bought. |
| Consumer income (inferior good) | Leftward shift (decrease) | Rise in income reduces demand for cheap instant‑noodles. |
| Prices of related goods | Substitutes: price ↑ → demand ↑; Complements: price ↑ → demand ↓ | Petrol price rise raises demand for electric cars (substitutes). |
| Tastes & preferences | Right shift if good becomes fashionable; left shift if it falls out of favour. | Health campaign boosts demand for bicycles. |
| Expectations of future price | Expect price rise → demand ↑ now; expect fall → demand ↓ now. | Anticipated holiday sales lead shoppers to buy early. |
| Population size | More people → demand ↑; fewer people → demand ↓. | Urban growth raises demand for housing. |
2.3 The Supply Curve
Shows the relationship between the price of a good (P) and the quantity supplied (Qs).
- Law of supply: As price rises, quantity supplied rises – the curve slopes upwards.
2.3.1 Movements Along the Supply Curve
A change in the price of the good itself causes a movement up or down the same curve.
2.3.2 Shifts of the Supply Curve
Any non‑price factor that changes the quantity supplied at every price shifts the whole curve.
| Determinant | Effect on Supply | Example |
|---|
| Technology | Rightward shift (increase) | New automated machinery lowers production cost. |
| Input prices | Higher input price → leftward shift (decrease) | Rising steel price reduces car production. |
| Expectations of future price | Expect price rise → supply ↓ now (hold back stock); expect fall → supply ↑ now. | Farmers store wheat anticipating higher future prices. |
| Number of sellers | More sellers → rightward shift; fewer sellers → leftward shift. | Entry of a new brewery expands beer supply. |
| Government taxes on producers | Tax → leftward shift (decrease) | Excise duty on cigarettes raises production cost. |
| Government subsidies to producers | Subsidy → rightward shift (increase) | Subsidy for renewable‑energy firms lowers their costs. |
2.4 Market Equilibrium
Equilibrium occurs where quantity demanded equals quantity supplied:
\(Q_d = Q_s\)
For linear functions:
\(Q_d = a - bP\)
\(Q_s = c + dP\)
Setting them equal and solving gives:
\(P^* = \dfrac{a - c}{b + d}\)
\(Q^* = a - bP^* = c + dP^* = \dfrac{ad + bc}{b + d}\)
2.4.1 Disequilibrium: Shortages and Surpluses
- Shortage: \(Q_d > Q_s\) (price below \(P^*\)). Upward pressure on price.
- Surplus: \(Q_s > Q_d\) (price above \(P^*\)). Downward pressure on price.
Typical exam diagrams:
- Price ceiling (horizontal line below \(P^*\)) → shortage.
- Price floor (horizontal line above \(P^*\)) → surplus.
2.5 Price Changes and Their Consequences
When a determinant shifts a curve, follow the five‑step method:
- Identify which curve shifts and in which direction.
- Redraw the curves on the same axes, keeping the original curve for reference.
- Mark the new intersection – the new equilibrium.
- Read the new equilibrium price (\(P_{new}\)) and quantity (\(Q_{new}\)).
- Compare with the original equilibrium and state whether price and/or quantity have risen or fallen.
2.5.1 Impact on Consumer Expenditure and Producer Revenue
- Consumer expenditure: \(P \times Q\) (price paid × quantity bought).
- Producer revenue: \(P \times Q\) (price received × quantity sold).
- When demand rises and supply is unchanged, both price and quantity increase → consumer expenditure usually rises, but the exact change depends on the price elasticity of demand.
- When supply falls and demand is unchanged, price rises while quantity falls → consumer expenditure is ambiguous; producer revenue typically falls unless supply is highly inelastic.
3. Elasticity
3.1 Price Elasticity of Demand (PED)
Definition: The percentage change in quantity demanded divided by the percentage change in price.
\( \displaystyle \text{PED} = \frac{\%\Delta Q_d}{\%\Delta P} = \frac{\Delta Q_d / Q_d}{\Delta P / P}\)
- PED > 1 → elastic (quantity responds strongly to price).
- PED = 1 → unit‑elastic.
- PED < 1 → inelastic (quantity responds weakly to price).
- PED = 0 → perfectly inelastic (vertical demand curve).
- PED = ∞ → perfectly elastic (horizontal demand curve).
Determinants of PED (mirrors demand‑shift determinants):
- Availability of close substitutes – more substitutes → more elastic.
- Proportion of income spent on the good – higher proportion → more elastic.
- Nature of the good – luxury goods are more elastic than necessities.
- Time horizon – demand is more elastic in the long run.
Revenue implications:
- If demand is elastic, a price rise reduces total revenue; a price cut increases it.
- If demand is inelastic, a price rise increases total revenue; a price cut reduces it.
3.2 Price Elasticity of Supply (PES)
Definition: The percentage change in quantity supplied divided by the percentage change in price.
\( \displaystyle \text{PES} = \frac{\%\Delta Q_s}{\%\Delta P} = \frac{\Delta Q_s / Q_s}{\Delta P / P}\)
- PES > 1 → supply is elastic (producers can quickly increase output).
- PES = 1 → unit‑elastic.
- PES < 1 → supply is inelastic (output cannot be changed much in the short run).
Determinants of PES:
- Availability of spare capacity – more spare capacity → more elastic.
- Time period – supply is more elastic in the long run.
- Mobility of factors of production – easily moved factors → more elastic.
- Complexity of production process – simple processes → more elastic.
Revenue implication for producers: The same logic as for demand applies, but using PES to judge how quantity supplied will respond to a price change.
4. Micro‑Economic Decision‑Makers (Sidebar)
- Households – decide how much to spend, save or borrow based on income, interest rates, cultural factors and future expectations.
- Firms – aim to maximise profit; decide how much to produce, what price to charge (in competitive markets they are price‑takers), and how many workers to employ.
- Workers (Labour market) – supply labour based on wages, working conditions, skill level; demand for labour comes from firms.
- Money & Banking – money serves as a medium of exchange, a unit of account and a store of value. Central banks control monetary policy (interest rates, reserve requirements) while commercial banks provide deposits and loans.
- Types of markets
- Competitive (many buyers & sellers, price takers).
- Monopoly (single seller, price maker).
- Oligopoly, monopolistic competition – not examined in depth for IGCSE but worth recognising.
5. Market Failure (Box)
When the free market does not allocate resources efficiently, government intervention may be required.
| Type of Failure | Key Feature | Typical Government Response |
|---|
| Public goods |
Non‑rival & non‑excludable (e.g., street lighting) |
Direct provision or financing through taxation. |
| Externalities |
Third‑party costs or benefits not reflected in market price (e.g., pollution) |
Taxes/subsidies, regulation, tradable permits. |
| Merit goods |
Undervalued by consumers (e.g., education, vaccinations) |
Subsidies, free provision, public campaigns. |
| Demerit goods |
Over‑consumed if left to market (e.g., cigarettes, alcohol) |
Excise duties, age restrictions, public‑health campaigns. |
| Monopoly power |
Single seller can set price above marginal cost |
Price caps, regulation, encouraging competition. |
6. Government & the Macro‑Economy (Snapshot)
6.1 Fiscal Policy
- Government spending – increases aggregate demand directly.
- Taxation – influences disposable income and consumption.
- Expansionary fiscal policy (↑ spending or ↓ taxes) → aims to boost growth and reduce unemployment.
- Contractionary fiscal policy (↓ spending or ↑ taxes) → aims to curb inflation.
6.2 Monetary Policy
- Controlled by the central bank (e.g., the Bank of England).
- Key tools: interest rates, open‑market operations, reserve requirements.
- Lower interest rates → cheaper borrowing → higher investment and consumption.
- Higher interest rates → opposite effect, used to fight inflation.
6.3 Supply‑Side Policies
- Measures that increase productive capacity and shift the PPC outward.
- Examples: improving education & training, investing in infrastructure, deregulation, tax incentives for R&D.
6.4 Macro‑Economic Objectives
| Objective | Desired Outcome | Typical Indicator |
|---|
| Economic Growth | Higher real GDP per capita | GDP growth rate |
| Low Unemployment | More people in work | Unemployment rate |
| Price Stability | Low, predictable inflation | Consumer Price Index (CPI) inflation rate |
| External Balance | Manageable current‑account deficit/surplus | Current‑account balance |
7. Worked Example (Linear Functions)
Demand: \(Q_d = 120 - 2P\)
Supply: \(Q_s = 20 + 3P\)
- Set demand equal to supply:
\(120 - 2P = 20 + 3P\)
- Solve for \(P\):
\(120 - 20 = 3P + 2P\) → \(100 = 5P\) → \(P^* = 20\)
- Find equilibrium quantity:
\(Q^* = 120 - 2(20) = 80\)
- Interpretation:
At £20 per unit the market clears with 80 units bought and sold.
- Impact of a £5 tax on producers (shifts supply left):
New supply: \(Q_s = 20 + 3(P - 5) = 5 + 3P\)
Set equal to original demand:
\(120 - 2P = 5 + 3P \;\Rightarrow\; 115 = 5P \;\Rightarrow\; P_{new}=23\)
New quantity: \(Q_{new}=120-2(23)=74\)
- Price paid by consumers rises from £20 → £23.
- Quantity falls from 80 → 74.
- Consumer expenditure: £23 × 74 = £1,702 (up from £1,600).
- Producer revenue (price received after tax): (£23 − £5) × 74 = £18 × 74 = £1,332 (down from £1,600).
- Because demand is relatively inelastic (PED ≈ 0.4), total revenue for producers falls.
8. Diagram Checklist (What to Draw in the Exam)
- Axes labelled “Price (P)” (vertical) and “Quantity (Q)” (horizontal).
- Downward‑sloping demand curve (label D) and upward‑sloping supply curve (label S).
- Equilibrium point (E) with arrows to label \(P^*\) and \(Q^*\).
- If a shift is required, draw the new curve (D′ or S′) and the new equilibrium (E′).
- Shortage or surplus area when price is set above or below \(P^*\).
- Price ceiling (horizontal line below \(P^*\)) – label “Ceiling” and show resulting shortage.
- Price floor (horizontal line above \(P^*\)) – label “Floor” and show resulting surplus.
- For elasticity questions, indicate a relatively steep (inelastic) or flat (elastic) curve and annotate the percentage changes.
9. Summary Checklist (Quick Revision)
- Define scarcity, opportunity cost and the four factors of production.
- Sketch a basic PPC and explain growth vs. recession shifts.
- State the law of demand and law of supply; draw their typical shapes.
- Distinguish movements along a curve from shifts of the whole curve.
- Recall the five demand determinants and five supply determinants, with a real‑world example for each.
- Calculate equilibrium price and quantity algebraically from linear equations.
- Explain shortages, surpluses, price ceilings and price floors.
- Define PED and PES, calculate them using the %‑change formula, and interpret the numerical value.
- Identify the determinants of PED and PES and describe how they affect revenue.
- Summarise the roles of households, firms, workers and banks in a market economy.
- List the main types of market failure and the typical government response.
- Outline the features of a market economic system and a mixed economic system.
- Recall the three macro‑economic policy tools (fiscal, monetary, supply‑side) and the four macro objectives.
- Practice drawing clear, labelled diagrams under timed conditions.