Interpretation of disequilibrium using demand and supply schedules

1. The Basic Economic Problem

1.1 Scarcity and Choice

• Human wants are unlimited, but resources (land, labour, capital, entrepreneurship) are limited → scarcity.
• Scarcity forces individuals, firms and governments to make choices about what to produce, how to produce and for whom to produce.

1.2 Factors of Production and Their Rewards

1.3 Opportunity Cost

The value of the next best alternative that is foregone when a choice is made.

• Consumer example: spending £50 on a concert ticket means giving up the chance to buy a new pair of shoes.
• Firm example: using a factory to produce cars means the opportunity cost is the profit that could have been earned by producing motorcycles instead.
• Government example: allocating budget to defence means less is available for education.

1.4 Production Possibility Curve (PPC)

• Shows the maximum combinations of two goods that can be produced with existing resources and technology.
• Key points to label on a diagram:

  • Axes – quantities of the two goods.
  • Efficient points – on the curve (full utilisation of resources).
  • Inefficient points – inside the curve (under‑utilisation, unemployment).
  • Unattainable points – outside the curve (insufficient resources/technology).
  • Economic growth – outward shift of the curve (more resources or better technology).
  • Economic decline – inward shift (natural disaster, war).

2. Allocation of Resources – Price Determination

2.1 The Role of Markets

• A market brings together buyers and sellers of a good or service.
• Resources are allocated through the price mechanism: interaction of demand and supply determines the price and the quantity exchanged.
• Key functions:

  • Facilitate exchange.
  • Provide information (prices signal scarcity and preferences).
  • Coordinate production decisions.

2.2 Demand

2.2.1 Definition

The quantity of a good that consumers are willing and able to buy at a given price, ceteris paribus (all other factors unchanged).

2.2.2 Individual vs. Market Demand

• Individual demand – one consumer’s willingness to buy.
• Market demand – the sum of all individual demands at each price.

2.2.3 Law of Demand

When price falls, quantity demanded rises (and vice‑versa), ceteris paribus.

2.2.4 Movements Along the Demand Curve

A change in the price of the good itself causes a movement up or down the same demand curve.

2.2.5 Shifts of the Demand Curve

Any change in a non‑price factor shifts the whole curve.

2.3 Supply

2.3.1 Definition

The quantity of a good that producers are willing and able to sell at a given price, ceteris paribus.

2.3.2 Individual vs. Market Supply

• Individual supply – one firm’s willingness to sell.
• Market supply – the sum of all individual supplies at each price.

2.3.3 Law of Supply

When price rises, quantity supplied rises (and vice‑versa), ceteris paribus.

2.3.4 Movements Along the Supply Curve

A change in the price of the good itself causes a movement up or down the same supply curve.

2.3.5 Shifts of the Supply Curve

Any change in a non‑price factor shifts the whole curve.

2.4 Demand and Supply Schedules

Schedules give the numerical relationship between price and quantity demanded or supplied.

These schedules can be expressed algebraically as:

\$Q_d = a - bP\$

\$Q_s = c + dP\$

where a, b, c, d are constants reflecting consumer preferences and producer costs.

2.5 Market Equilibrium

• Equilibrium occurs where quantity demanded equals quantity supplied (Q_d = Q_s).
• From the tables above, equilibrium price Pₑ = $16 and equilibrium quantity Qₑ = 60 units.
• Diagram conventions:

  • Label the vertical axis “Price (P)” and the horizontal axis “Quantity (Q)”.
  • Draw the demand curve (downward sloping) and the supply curve (upward sloping).
  • Mark the intersection as point E and write Pₑ and Qₑ on the axes.
  • Shade the area above Pₑ (if price is higher) to illustrate a surplus; shade the area below Pₑ for a shortage.

2.6 Disequilibrium – Surplus and Shortage

• Surplus (Excess Supply): P > Pₑ → Q_s > Q_d. Sellers will tend to lower price.
• Shortage (Excess Demand): P < Pₑ → Q_d > Q_s. Buyers will tend to bid price up.

2.6.1 Interpreting Disequilibrium Using the Schedules

1. Locate the chosen price in both tables.
2. Read the corresponding quantities Q_d and Q_s.
3. Compare:

   • If Q_s > Q_d → surplus → downward pressure on price.
   • If Q_d > Q_s → shortage → upward pressure on price.

4. Predict the direction of price movement until the market returns to equilibrium.

2.6.2 Worked Example – Government Price Ceiling

Suppose the government imposes a maximum legal price (price ceiling) of $12.

• At $12, demand (80) exceeds supply (40) → shortage, putting upward pressure on price.
• The ceiling prevents the price from rising, so the shortage persists unless the government intervenes (rationing, subsidies, or removal of the ceiling).

2.7 Government Intervention in Markets

2.7.1 Price Controls

• Price ceiling (maximum price) – set below the equilibrium price → shortage.
• Price floor (minimum price) – set above the equilibrium price → surplus (e.g., minimum wage, agricultural price support).

2.7.2 Tax

• Imposed on producers (excise) or consumers (sales tax).
• Graphically: shifts the supply curve leftward (tax on producers) or the demand curve leftward (tax on consumers) by the amount of the tax.
• Result: higher price for consumers, lower price received by producers, and a dead‑weight loss (inefficiency).

2.7.3 Subsidy

• Payment from government to producers (or consumers).
• Shifts the supply curve rightward (producer subsidy) or the demand curve rightward (consumer subsidy).
• Result: lower price for consumers, higher price received by producers, and an increase in equilibrium quantity.

2.7.4 Regulation, Quotas & Licences

• Regulation can set standards (e.g., safety, environmental) that raise production costs → leftward shift of supply.
• Import quotas limit the quantity of a good that can be imported → reduce supply, raise price.
• Licences (e.g., taxi licences) restrict the number of sellers, shifting supply left.

2.7.5 Privatisation & Nationalisation

• Privatisation – transfer of state‑owned enterprises to private ownership; aims to increase efficiency via profit motive.
• Nationalisation – transfer of private firms to state ownership; used to achieve social objectives (e.g., universal service).

2.8 Price Elasticity of Demand (PED)

2.8.1 Definition & Formula

Percentage change in quantity demanded divided by the percentage change in price.

\$\$\text{PED} = \frac{\%\Delta Q_d}{\%\Delta P}

= \frac{\Delta Qd / Qd}{\Delta P / P}\$\$

2.8.2 Interpretation & Terminology (as required by the syllabus)

• Elastic demand (|PED| > 1) – quantity changes proportionally more than price.
• Inelastic demand (|PED| < 1) – quantity changes proportionally less than price.
• Unitary elastic demand (|PED| = 1) – proportional change.
• Perfectly elastic demand (|PED| = ∞) – horizontal demand curve; any price increase eliminates all sales.
• Perfectly inelastic demand (|PED| = 0) – vertical demand curve; quantity demanded does not change as price changes.

2.8.3 Determinants of PED

2.8.4 Worked Calculation (using the schedule)

Calculate PED between \$14 and \$16:

• ΔP = \$16 – \$14 = $2
• Average price = (\$16 + \$14)/2 = $15
• ΔQ_d = 60 – 70 = –10
• Average quantity = (60 + 70)/2 = 65
• \$\text{PED} = \frac{-10/65}{2/15} = \frac{-0.154}{0.133} \approx -1.16\$
• Since |PED| > 1, demand is elastic over this price range.

2.9 Price Elasticity of Supply (PES)

2.9.1 Definition & Formula

Percentage change in quantity supplied divided by the percentage change in price.

\$\$\text{PES} = \frac{\%\Delta Q_s}{\%\Delta P}

= \frac{\Delta Qs / Qs}{\Delta P / P}\$\$

2.9.2 Interpretation & Terminology

• Elastic supply (PES > 1) – producers can increase output quickly when price rises.
• Inelastic supply (PES < 1) – output changes little with price.
• Unitary elastic supply (PES = 1).
• Perfectly elastic supply (PES = ∞) – horizontal supply curve; producers are willing to supply any quantity at a given price.
• Perfectly inelastic supply (PES = 0) – vertical supply curve; quantity supplied is fixed regardless of price.

2.9.3 Determinants of PES

2.9.4 Worked Calculation (using the schedule)

Calculate PES between \$14 and \$16:

• ΔP = \$2, average price = \$15
• ΔQ_s = 60 – 50 = 10, average quantity = 55
• \$\text{PES} = \frac{10/55}{2/15} = \frac{0.182}{0.133} \approx 1.37\$
• Supply is elastic over this range.

2.10 Using Elasticities to Predict Revenue and Policy Impact

• If demand is elastic, a price rise reduces total revenue; a price fall increases revenue.
• If demand is inelastic, a price rise increases total revenue; a price fall reduces revenue.
• Governments consider elasticity when designing taxes (higher revenue from inelastic goods) or subsidies (greater impact on elastic goods).

3. Micro‑Economic Decision‑Makers

3.1 Households (Consumers)

• Make consumption choices to maximise utility subject to income and prices.
• Factors influencing demand: income, tastes, expectations, prices of related goods, number of buyers.
• Budget constraint: Income = Σ (Price × Quantity).

3.2 Workers (Labour Suppliers)

• Decide how many hours to work based on wages, working conditions, alternative leisure activities, and expectations of future wages.
• Labour supply curve is generally upward sloping, but can be backward‑bending at high wages.

3.3 Firms (Producers)

3.3.1 Production & Costs

• Fixed costs (FC) – do not vary with output (e.g., rent).
• Variable costs (VC) – vary with output (e.g., raw materials).
• Total cost (TC) = FC + VC.
• Average cost (AC) = TC / Q; Marginal cost (MC) = ΔTC / ΔQ.
• In the short run, MC typically falls, reaches a minimum, then rises (U‑shaped).

3.3.2 Revenue

• Total revenue (TR) = P × Q.
• Average revenue (AR) = TR / Q (equals price in perfect competition).
• Marginal revenue (MR) = ΔTR / ΔQ.

3.3.3 Profit Maximisation

Firm produces where MR = MC. In perfect competition, this is also where P = MC.

3.3.4 Market Structures (Cambridge IGCSE focus)

3.4 Money & Banking

• Functions of money: medium of exchange, unit of account, store of value.
• Characteristics: acceptability, divisibility, durability, portability, uniformity.
• Banks accept deposits and provide loans; the interest rate is the price of borrowing.
• Central bank (e.g., Bank of England) controls the money supply and influences interest rates.

4. Macro‑Economic Decision‑Makers

4.1 Government (Fiscal Policy)

• Uses taxation and government spending to influence aggregate demand.
• Expansionary fiscal policy: increase spending or cut taxes → shifts AD right → higher output and employment (but may raise inflation).
• Contractionary fiscal policy: decrease spending or raise taxes → shifts AD left → lower inflation (risk of higher unemployment).
• Objectives: economic growth, low unemployment, price stability.

4.2 Central Bank (Monetary Policy)

• Controls the money supply and interest rates.
• Expansionary monetary policy: lower interest rates, increase money supply → AD shifts right.
• Contractionary monetary policy: raise interest rates, reduce money supply → AD shifts left.
• Tools: open‑market operations, reserve requirements, policy interest rates.

4.3 International Sector

• Balance of payments (BOP) records all transactions with the rest of the world.

  • Current account – trade in goods & services, income, transfers.
  • Capital account – financial flows (investment, loans).

• Exchange rate regimes:

  • Fixed (pegged) – government/bank intervenes to maintain a set rate.
  • Floating – market determines the rate.

• Trade policies:

  • Tariffs – tax on imports (raises domestic price, protects local industry).
  • Quotas – limit the quantity of imports.
  • Subsidies – support domestic producers.

5. Market Failure

• Occurs when the free market does not allocate resources efficiently.

5.1 Public Goods

• Non‑rival and non‑excludable (e.g., street lighting, national defence).
• Market under‑provides them → government provision.

5.2 Merit and Demerit Goods

• Merit goods – socially desirable (e.g., education, vaccination); often under‑consumed.
• Demerit goods – socially undesirable (e.g., cigarettes, alcohol); often over‑consumed.

5.3 Externalities

• Positive externality – third‑party benefit (e.g., beekeeper’s bees pollinating nearby crops).
• Negative externality – third‑party cost (e.g., factory pollution).
• Government remedies: taxes on negative externalities, subsidies on positive externalities, regulation.

5.4 Information Failure

• When buyers or sellers lack full information (e.g., hidden defects), market outcomes may be inefficient.
• Possible solutions: labelling laws, consumer protection agencies.

5.5 Monopoly Power

• Single seller can restrict output and raise price above marginal cost → dead‑weight loss.
• Remedies: antitrust legislation, price regulation, encouraging competition.

6. Mixed Economic System

• Definition: An economy that combines a market system with government intervention to correct failures and achieve social goals.
• Characteristics:

  • Private ownership of most resources.
  • Government provides public goods, regulates externalities, and may run key services (health, education).
  • Use of fiscal and monetary policy to stabilise the economy.

• Advantages (AO3 evaluation points):

  • Efficient allocation of many goods through the price mechanism.
  • Government can address market failures and promote equity.
  • Provides a safety net (unemployment benefits, pensions).

• Disadvantages:

  • Potential for government failure (inefficient bureaucracy, wrong policy choices).
  • Higher taxes may discourage investment and work effort.
  • Risk of over‑regulation reducing incentives for innovation.

7. Summary of Key Diagram Conventions (for exam answers)

• Always label axes (Price – P, Quantity – Q).
• Mark equilibrium point E and write Pₑ and Qₑ.
• Indicate surplus (excess supply) above Pₑ and shortage (excess demand) below Pₑ.
• When showing a price ceiling/floor, draw a horizontal line at the imposed price and shade the resulting shortage or surplus.
• For taxes/subsidies, show the parallel shift of the relevant curve and label the amount of the tax/subsidy.
• Elasticity diagrams: use a steep demand curve for inelastic demand, a flat curve for elastic demand; similarly for supply.