Use of demand and supply diagrams to illustrate the impact of changes in market conditions

Allocation of Resources – Price Changes (Cambridge IGCSE/A‑Level Economics 0455)

Understanding how market conditions affect price, quantity, consumer expenditure and firm revenue is essential for analysing the allocation of resources. This note explains how to use demand‑ and supply‑diagrams, covers price‑elasticity concepts, government interventions and a brief overview of market economic systems, all aligned with the Cambridge syllabus.

1. The Basic Demand‑Supply Model

• Demand curve: \(Q_d = f(P)\) – quantity demanded falls as price rises (downward‑sloping).
• Supply curve: \(Q_s = g(P)\) – quantity supplied rises as price rises (upward‑sloping).
• Equilibrium: where \(Q_d = Q_s\). The intersection gives the equilibrium price (\(P^{*}\)) and quantity (\(Q^{*}\)).

2. Shifts in Demand

A factor other than the good’s own price (income, tastes, price of related goods, expectations, number of buyers) moves the whole demand curve.

Factor	Direction of demand shift	Effect on \(P^{*}\)	Effect on \(Q^{*}\)
Increase in consumer income (normal good)	Rightward	Rise	Rise
Decrease in consumer income (normal good)	Leftward	Fall	Fall
Price rise of a substitute	Rightward	Rise	Rise
Price rise of a complement	Leftward	Fall	Fall
Expectations of higher future price	Rightward (current demand ↑)	Rise	Rise

3. Shifts in Supply

Changes in production costs, technology, number of sellers, or government policy move the whole supply curve.

Factor	Direction of supply shift	Effect on \(P^{*}\)	Effect on \(Q^{*}\)
Improvement in technology	Rightward	Fall	Rise
Increase in input prices	Leftward	Rise	Fall
More firms enter the market	Rightward	Fall	Rise
Regulatory restrictions (e.g., quotas)	Leftward	Rise	Fall
Expectations of future price rise (producers hold back stock)	Leftward (short‑run)	Rise	Fall

4. Simultaneous Shifts in Demand and Supply

When both curves move, the direction of change in price and quantity depends on the relative magnitude of the shifts.

• Both shift rightward: Quantity definitely rises; price may rise, fall or stay the same.
• Both shift leftward: Quantity definitely falls; price outcome is ambiguous.
• Demand rightward, supply leftward: Price rises; quantity effect is uncertain.
• Demand leftward, supply rightward: Price falls; quantity effect is uncertain.

Combination of shifts	Direction of \(P^{*}\)	Direction of \(Q^{*}\)
↑D & ↑S	↑, ↓ or ↔ (depends on magnitude)	↑
↓D & ↓S	↑, ↓ or ↔ (depends on magnitude)	↓
↑D & ↓S	↑	↑ or ↓ (depends)
↓D & ↑S	↓	↑ or ↓ (depends)

5. Government Interventions in Markets

5.1 Price Floors (Minimum Prices)

• Set above the equilibrium price → creates a surplus (excess supply).
• Typical example: agricultural price support.

5.2 Price Ceilings (Maximum Prices)

• Set below the equilibrium price → creates a shortage (excess demand).
• Typical example: rent control.

5.3 Specific Taxes

A per‑unit tax on producers shifts the supply curve upward (or leftward) by the amount of the tax.

• Consumer price rises (price paid = \(P_c\)).
• Producer price falls (price received = \(P_p = P_c - t\)).
• Quantity sold falls.

5.4 Specific Subsidies

A per‑unit subsidy to producers shifts the supply curve downward (or rightward) by the amount of the subsidy.

• Consumer price falls (price paid = \(P_c\)).
• Producer price rises (price received = \(P_p = P_c + s\)).
• Quantity sold rises.

6. Consequences of Price Changes for Consumer Expenditure and Firm Revenue (Syllabus 2.5)

When price changes, three related variables are affected:

1. Consumer expenditure = \(P \times Q_d\).
2. Firm revenue (Total Revenue, TR) = \(P \times Q_s\).
3. Market outcome – surplus or shortage.

Example – Luxury good (elastic demand)

• Initial: \(P_0 = £10\), \(Q_0 = 1,000\) → TR\(_0 = £10,000\).
• Price rises to \(P_1 = £12\) (↑20 %). Quantity falls to \(Q_1 = 800\) (↓20 %). TR\(_1 = £9,600\).
• Because \(|\text{PED}|>1\), total revenue falls when price rises.

Example – Necessity (inelastic demand)

• Initial: \(P_0 = £5\), \(Q_0 = 2,000\) → TR\(_0 = £10,000\).
• Price rises to \(P_1 = £6\) (↑20 %). Quantity falls to \(Q_1 = 1,800\) (↓10 %). TR\(_1 = £10,800\).
• Because \(|\text{PED}|<1\), total revenue rises when price rises.

These calculations are the basis for answering “what happens to consumer spending/firm revenue when price changes?” – a common Paper 2 command.

7. Price Elasticity of Demand (PED) – Syllabus 2.6

7.1 Definition & Formula

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

\[ \text{PED} = \frac{\%\Delta Q_d}{\%\Delta P} \]

7.2 Mid‑point (Arc) Formula – required for “calculate” questions

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

This formula gives the same elasticity regardless of the direction of the price change.

7.3 Quick‑Calc Checklist

1. Identify the initial and new price (\(P_1, P_2\)) and quantity (\(Q_1, Q_2\)).
2. Calculate \(\%\Delta P = \dfrac{P_2-P_1}{(P_1+P_2)/2}\times 100\).
3. Calculate \(\%\Delta Q = \dfrac{Q_2-Q_1}{(Q_1+Q_2)/2}\times 100\).
4. Divide \(\%\Delta Q\) by \(\%\Delta P\) to obtain PED.
5. Interpret the sign (ignore the negative sign for magnitude) and compare with 1.

7.4 Interpretation of the Coefficient

PED value (|PED|)	Demand type	Revenue implication when price rises
> 1	Elastic	TR falls
= 1	Unitary elastic	TR unchanged
< 1	Inelastic	TR rises
0	Perfectly inelastic (vertical demand)	TR unchanged regardless of price
∞	Perfectly elastic (horizontal demand)	Any price rise eliminates all sales

7.5 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
Necessity vs. luxury	Necessities → inelastic; luxuries → elastic
Time‑period for adjustment	Longer period → more elastic
Definition of the market (broad vs. narrow)	Narrow definition (e.g., specific brand) → more elastic

7.6 Graphical Representation

A flatter (more horizontal) demand curve indicates a higher (more elastic) PED; a steeper (more vertical) curve indicates a lower (more inelastic) PED. The midpoint method is illustrated by drawing a line between two points on the curve and measuring the percentage changes.

7.7 Using PED in Decision‑Making

• Firms: raise price if demand is inelastic, cut price if demand is elastic to maximise total revenue.
• Government: anticipate how a tax or price control will affect consumer expenditure and tax revenue; choose policies that minimise welfare loss.

8. Price Elasticity of Supply (PES) – Syllabus 2.7

8.1 Definition & Formula

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

\[ \text{PES} = \frac{\%\Delta Q_s}{\%\Delta P} \]

8.2 Mid‑point (Arc) Formula

\[ \text{PES}_{\text{mid}} = \frac{\displaystyle \frac{Q_{s2} - Q_{s1}}{(Q_{s1}+Q_{s2})/2}} {\displaystyle \frac{P_2 - P_1}{(P_1+P_2)/2}} \]

8.3 Determinants of PES

Determinant	Effect on elasticity
Availability of spare capacity	More spare capacity → more elastic
Time‑period for adjustment	Longer period → more elastic (firms can re‑allocate resources)
Mobility of factors of production	Highly mobile factors → more elastic
Complexity of production process	Complex/technology‑intensive → less elastic
Number of firms in the market	More firms → more elastic (greater total industry response)

8.4 Graphical Representation

A relatively flat supply curve indicates a high PES (quantity supplied changes a lot with price); a steep supply curve indicates a low PES. The diagram below can be used to illustrate the effect of a tax on a market with either elastic or inelastic supply.

8.5 Using PES in Decision‑Making

• Policy makers: a tax on a good with inelastic supply will generate more revenue with a smaller reduction in output.
• Firms: in markets with elastic supply, producers can increase output quickly in response to price rises, affecting short‑run profit strategies.

9. Market Economic Systems (Syllabus 2.8)

A brief comparison to help students place the price‑mechanism within broader economic systems.

System	Key Features	Advantages	Disadvantages
Market (pure) economy	Resources allocated by price mechanism; private ownership; profit motive.	Efficient allocation, innovation, consumer choice.	Potential inequality; market failures (externalities, public goods).
Mixed economy	Market forces dominate but government intervenes (taxes, subsidies, regulation).	Combines efficiency with equity; can correct failures.	Risk of over‑regulation; possible government failure.
Command (planned) economy	Central authority decides production, prices and distribution.	Can achieve specific social goals; reduces inequality.	Often inefficient; shortages or surpluses; lack of incentives.

10. Evaluation of Government Interventions (AO3)

When answering essay‑type questions, weigh advantages against disadvantages and link to diagrams (e.g., dead‑weight loss).

Intervention	Potential Advantages	Potential Disadvantages / Unintended Consequences
Price floor	Protects producers’ income; prevents “race to the bottom”.	Creates surplus → waste, storage costs, may require government purchase; keeps inefficient firms alive.
Price ceiling	Makes essential goods affordable; can reduce poverty.	Creates shortage → black markets, reduced quality, long queues; discourages investment.
Specific tax	Raises government revenue; can correct negative externalities (e.g., cigarettes).	If demand is inelastic, burden falls on consumers; may encourage smuggling or evasion.
Subsidy	Encourages production/consumption of socially desirable goods (e.g., renewable energy); lowers price for consumers.	Fiscal cost; risk of over‑production; can distort market signals.

11. Summary Table – How Market Conditions Affect Price and Quantity

Market change	Curve that shifts	Direction of shift	Effect on \(P^{*}\)	Effect on \(Q^{*}\)
Higher consumer income (normal good)	Demand	Rightward	↑	↑
Improved production technology	Supply	Rightward	↓	↑
Price floor set above equilibrium	Artificial price ↑	—	↑	↓ (surplus)
Price ceiling set below equilibrium	Artificial price ↓	—	↓	↑ (shortage)