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.

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

1.4 Production Possibility Curve (PPC)

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{Q2-Q1}{(Q1+Q2)/2}}{\displaystyle \frac{P2-P1}{(P1+P2)/2}}

\qquad\qquad

\text{PES} \;=\; \frac{\displaystyle \frac{Q2-Q1}{(Q1+Q2)/2}}{\displaystyle \frac{P2-P1}{(P1+P2)/2}}

\]

Interpretation table

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)

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.

3. Macro‑Economic Context

3.1 Key Macro Indicators

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.

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 - bPe = c + dPe \;\Longrightarrow\; Pe = \frac{a - c}{b + d},\qquad Qe = c + dP_e

\]

Excess quantity at any price P

\[

\text{Excess} = Qs - Qd = (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 - 4Pe = 20 + 2Pe \;\Longrightarrow\; 180 = 6Pe \;\Longrightarrow\; Pe = 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.

5. Micro‑Economic Decision‑Makers & Market Types

5.1 Decision‑Makers

5.2 Market Structures (Cambridge focus)

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).