How price changes are caused by changes in demand and supply

IGCSE / A‑Level Economics – Revision Notes (Cambridge 0455)

Learning Objectives

• Explain the basic economic problem and the role of scarcity.
• Describe how markets allocate resources using demand, supply and price.
• Analyse how changes in demand and supply cause movements in market price and quantity.
• Calculate and interpret price elasticities of demand and supply.
• Identify different forms of market failure and evaluate government‑intervention tools.
• Explain the decision‑making of households, firms and government (micro‑decision‑makers).
• Summarise the main macro‑economic objectives and policies.
• Discuss the causes and consequences of economic development.
• Explain the benefits and problems of international trade and globalisation.
• Develop AO3 evaluation skills – weighing advantages, disadvantages and uncertainties.

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1. The Basic Economic Problem

1.1 Scarcity & Choice

• Scarcity: limited resources (land, labour, capital, enterprise) versus unlimited wants.
• Opportunity cost: the next best alternative fore‑gone when a choice is made.

1.2 Factors of Production & Their Rewards

• Land – rent
• Labour – wages
• Capital – interest
• Enterprise – profits

1.3 Economic Goods vs Free Goods

• Economic goods: scarce; must be produced using resources (e.g., smartphones).
• Free goods: abundant; no opportunity cost (e.g., air, seawater).

1.4 Production Possibility Curve (PPC)

• Shows the maximum combinations of two goods that can be produced with existing resources and technology.
• Points **inside** the curve – under‑utilisation; **on** the curve – efficient; **outside** – unattainable.
• Right‑hand shift = economic growth (more resources or better technology); left‑hand shift = contraction.

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2. Allocation of Resources – Markets, Price Changes & Elasticities

2.1 Market vs Mixed Economic Systems

• Market (pure) economy: resources allocated by price mechanism; private ownership of resources.
• Mixed economy: market mechanism plus government intervention to correct market failure, provide public goods, or achieve equity.
• Arguments **for** market: efficiency, consumer choice, innovation.
• Arguments **against** market: inequality, externalities, provision of public goods.
• Arguments **for** mixed: can address failures, improve equity.
• Arguments **against** mixed: risk of inefficiency, bureaucracy, distortion of incentives.

2.2 Demand and Supply Basics

• Demand: quantity of a good consumers are willing & able to buy at each price, ceteris paribus.
• Supply: quantity of a good producers are willing & able to sell at each price, ceteris paribus.
• Market equilibrium: where the demand curve (D) meets the supply curve (S). At this price (Pₑ) quantity demanded equals quantity supplied (Qₑ).
• Movement vs. shift: a change in price → movement along a curve; any other factor (income, technology, input price, etc.) → whole curve shifts.

2.3 How Changes in Demand and Supply Move the Price

Change	Direction of Curve Shift	Effect on Equilibrium Price (Pₑ)	Effect on Equilibrium Quantity (Qₑ)	Reason (shortage / surplus)
Increase in demand	Right‑hand	↑	↑	At old price, QD > QS → shortage → price rises
Decrease in demand	Left‑hand	↓	↓	At old price, QS > QD → surplus → price falls
Increase in supply	Right‑hand	↓	↑	At old price, QS > QD → surplus → price falls
Decrease in supply	Left‑hand	↑	↓	At old price, QD > QS → shortage → price rises

2.4 Simultaneous Shifts

1. Both curves shift in the same direction (e.g., increase in demand + increase in supply)
   • Quantity definitely moves in the direction of the shifts (↑ if both right‑hand, ↓ if both left‑hand).
   • Price change is ambiguous – depends on which shift is larger.
2. Curves shift in opposite directions (e.g., increase in demand + decrease in supply)
   • Price moves in the direction of the larger shift.
   • Quantity change is ambiguous – depends on relative magnitudes.

2.5 Market Failure

• Public goods: non‑rival and non‑excludable (e.g., street lighting).
• Merit goods: under‑consumed if left to market (e.g., education, vaccinations).
• De‑merit goods: over‑consumed if left to market (e.g., cigarettes, alcohol).
• Externalities: spill‑over effects on third parties.
  • Positive (e.g., immunisation).
  • Negative (e.g., pollution).
• Monopoly power: single seller can set price above marginal cost, leading to higher price & lower output.

2.6 Government Intervention (Micro‑intervention Tools)

Tool	Purpose (Cambridge terminology)	Effect on Price / Quantity
Maximum price (price ceiling)	Protect consumers (e.g., rent control)	Legal max < Pₑ → shortage, price falls to ceiling
Minimum price (price floor)	Support producers (e.g., minimum wage)	Legal min > Pₑ → surplus, price rises to floor
Direct tax (e.g., excise duty)	Reduce negative externalities or raise revenue	Supply curve shifts left; price to buyers ↑, price to sellers ↓; quantity ↓
Indirect tax (e.g., VAT)	Raise general revenue; can affect demand	Increases price of final good; demand may shift left if price‑elastic
Subsidy	Encourage positive externalities or support producers	Supply curve shifts right; price to buyers ↓, price to sellers ↑; quantity ↑
Regulation / Quota	Control quantity (e.g., fishing quota)	Directly limits Q; usually raises price
Direct provision	Government supplies a good directly (e.g., NHS)	Creates a parallel supply; can reduce price and increase quantity for consumers
Nationalisation	Transfer private industry to public ownership	May improve equity; efficiency depends on management
Privatisation	Transfer public industry to private ownership	Often increases efficiency; may raise price or reduce access

Evaluation points: administrative cost, black‑market risk, equity vs efficiency, impact on incentives, time‑lag.

2.7 Price Elasticity of Demand (PED)

• Definition: % change in quantity demanded ÷ % change in price.
• Formula: PED = (ΔQ / Q) ÷ (ΔP / P) or PED = (ΔQ / ΔP) × (P / Q).
• Interpretation:
  • |PED| > 1 → elastic (quantity reacts strongly).
  • |PED| = 1 → unit‑elastic.
  • |PED| < 1 → inelastic (quantity reacts weakly).
  • PED = 0 → perfectly inelastic (vertical demand).
  • PED = ∞ → perfectly elastic (horizontal demand).
• Determinants: availability of substitutes, proportion of income spent, necessity vs luxury, time‑frame, definition of market.
• Revenue implication:
  • Elastic demand → price rise reduces total revenue.
  • Inelastic demand → price rise increases total revenue.
• Example: A 10 % rise in petrol price raises total tax revenue because demand for petrol is relatively inelastic in the short run.

2.8 Price Elasticity of Supply (PES)

• Definition: % change in quantity supplied ÷ % change in price.
• Determinants: production‑time period, spare capacity, mobility of factors, availability of raw materials, technological flexibility.
• Typical pattern: short‑run supply is usually inelastic; long‑run supply becomes more elastic as firms can adjust plant and labour.
• Example: Agricultural output is inelastic in the short run because crops cannot be harvested faster, but in the long run farmers can switch to higher‑yield varieties, making supply more elastic.

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3. Micro‑Economic Decision‑Makers

3.1 Households

• Goal: maximise utility (satisfaction) subject to income and prices.
• Key decisions: consumption vs saving, labour supply (work vs leisure), choice of goods.
• Core concepts: marginal utility, budget constraint, indifference curve (A‑Level).

3.2 Firms

• Goal: maximise profit = total revenue – total cost.
• Short‑run costs: fixed cost (FC), variable cost (VC), total cost (TC = FC + VC), average cost (AC), marginal cost (MC).
• Revenue: total revenue (TR = P × Q), average revenue (AR = TR/Q), marginal revenue (MR = ΔTR/ΔQ).
• Market structures (Cambridge focus):
  • Perfect competition – many sellers, price‑taker, horizontal demand.
  • Monopoly – single seller, price‑setter, downward‑sloping demand.
  • Monopolistic competition & oligopoly – briefly for A‑Level (product differentiation, barriers to entry).

3.3 Government (as a decision‑maker)

• Sets macro‑policy (fiscal, monetary, supply‑side) and micro‑policy (intervention tools).
• Balances objectives: economic growth, low unemployment, price stability, equitable income distribution, external balance.

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4. Macro‑Economy – Objectives & Policies

4.1 Main Objectives

1. Economic growth (increase in real GDP).
2. Low unemployment.
3. Price stability (low inflation).
4. Equitable distribution of income.
5. External balance (balance of payments).

4.2 Fiscal Policy

• Expansionary: increase government spending and/or cut taxes → AD ↑ → higher output & employment (possible inflation).
• Contractionary: decrease spending and/or raise taxes → AD ↓ → lower inflation (possible rise in unemployment).
• Evaluation: time lags, crowding‑out, impact on public debt, distributional effects.

4.3 Monetary Policy (Central Bank)

• Instruments: policy interest rate, open‑market operations, reserve requirements.
• Expansionary: lower interest rates → borrowing ↑ → AD ↑.
• Contractionary: raise rates → borrowing ↓ → AD ↓.
• Evaluation: liquidity trap, exchange‑rate effects, time‑lag.

4.4 Supply‑Side Policies

• Improve productivity: training, R&D, infrastructure.
• Labour‑market reforms: reduce statutory minimum wage, deregulation, flexible working.
• Tax incentives for investment and entrepreneurship.
• Evaluation: long‑run impact, implementation time, possible distributional consequences.

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5. Economic Development

• Indicators: GDP per capita, Human Development Index (HDI), life expectancy, literacy rates.
• Causes of growth: capital accumulation, human capital, technology, institutions, openness to trade.
• Barriers: political instability, poor infrastructure, low education, disease, corruption.
• Policies: attract foreign direct investment (FDI), aid & concessional loans, micro‑finance, education & health programmes.
• Evaluation: aid dependency, “brain drain”, sustainability of growth, environmental impact.

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6. International Trade & Globalisation

• Reasons for trade: comparative advantage, economies of scale, variety, competition.
• Benefits: higher real incomes, cheaper imports, technology transfer.
• Costs: domestic job losses, trade deficits, dependence on foreign markets.
• Trade barriers (Cambridge list): tariffs, quotas, subsidies, voluntary export restraints, import licences.
• International organisations: World Trade Organisation (WTO), International Monetary Fund (IMF), World Bank.
• Evaluation: protectionism vs free trade, terms of trade, impact on developing economies, political considerations.

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7. Evaluation Skills (AO3)

1. Identify the relevant theory. (e.g., demand‑shift, elasticity, market failure.)
2. Apply the theory to a specific context. Use real‑world examples (e.g., coffee demand rise after health study).
3. Analyse likely outcomes. Discuss direction of price, quantity, revenue, welfare.
4. Weigh advantages and disadvantages. Consider efficiency, equity, feasibility, time‑lag, unintended consequences.
5. Conclude with a balanced judgement. State which outcome is most probable and why, acknowledging uncertainty.

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8. Real‑World Illustrations of Price Changes

• Demand increase: Health research links omega‑3 to heart health → fish consumption rises → fish price rises.
• Supply decrease: Drought in Kenya reduces maize harvest → maize supply falls → price spikes.
• Simultaneous shift: Rising incomes (demand ↑) and improved farming techniques (supply ↑) in Brazil’s soy market → quantity ↑, price relatively stable.
• Elasticity in action: Petrol has inelastic demand; a 10 % tax increase raises price but total tax revenue also rises because consumption falls only slightly.
• Government intervention: UK sugary‑drink tax (direct tax) shifts supply left, price rises, consumption falls, public‑health benefit achieved.

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9. Summary Checklist (AO2)

• Identify whether a change is a **shift** of the whole curve or a **movement** along it.
• State the direction of the shift (right/left) and the underlying cause (income, price of related good, technology, input price, etc.).
• Predict the resulting direction of change in equilibrium **price** and **quantity**.
• Explain the mechanism (shortage → price rise; surplus → price fall).
• Calculate or interpret the relevant **elasticity** if required.
• Consider any **government policy** that could alter the outcome and evaluate its likely effectiveness.
• Use a real‑world example to illustrate each point.

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Suggested Diagrams (for exam practice)

• Demand‑shift diagram (right‑hand shift) showing new equilibrium.
• Supply‑shift diagram (left‑hand shift) showing new equilibrium.
• Simultaneous shift (both curves right) – highlight ambiguous price change.
• Price ceiling and price floor – illustrate surplus/shortage.
• Tax on a good – show supply curve shifting left and incidence split.
• Subsidy – show supply curve shifting right.
• PPC with a right‑hand shift (economic growth) and a point beyond the original curve.
• Elastic vs inelastic demand curves with total‑revenue illustration.