Roles of buyers and sellers
Allocation of Resources – The Role of Markets
2.1 The role of markets in allocating resources (price mechanism)
In a market economy the three fundamental allocation questions are:
- What goods and services should be produced?
- How should they be produced?
- For whom are they produced?
The price mechanism answers these questions by turning information about scarcity, costs and willingness to pay into price signals. The flow is shown in the diagram below:
2.2 Demand
Definition: Demand is the quantity of a good or service that buyers are willing and able to purchase at each possible price, ceteris paribus.
Individual vs. market demand
- Individual demand – the schedule of one consumer.
- Market demand – the horizontal sum of all individual demand schedules.
Worked example – horizontal summation
Individual demand schedules (price £, quantity demanded):
| Price (£) | Consumer A | Consumer B |
|---|---|---|
| 2 | 4 | 3 |
| 4 | 2 | 1 |
| 6 | 0 | 0 |
Market demand at each price = A + B:
| Price (£) | Market demand |
|---|---|
| 2 | 7 |
| 4 | 3 |
| 6 | 0 |
This horizontal addition produces the market‑demand curve.
Demand curve
Price (P) is plotted on the vertical axis, quantity demanded (Qd) on the horizontal axis. The curve slopes downwards because, other things being equal, a lower price encourages a larger quantity demanded.
Movements vs. shifts
- Movement along the curve: caused only by a change in the price of the good itself.
- Shift of the curve: caused by any of the determinants listed below.
Determinants that shift demand
| Determinant | Effect on demand curve |
|---|---|
| Income (normal goods) | Shift right (increase) |
| Income (inferior goods) | Shift left (decrease) |
| Tastes & preferences | Right if favour, left if disfavour |
| Prices of related goods | Substitutes ↑ → right; Complements ↑ → left |
| Expectations of future price/availability | Higher expected future price → right now |
| Number of buyers | More buyers → right |
2.3 Supply
Definition: Supply is the quantity of a good or service that producers are willing and able to sell at each possible price, ceteris paribus.
Individual vs. market supply
- Individual supply – the schedule of one firm.
- Market supply – the horizontal sum of all individual supply schedules.
Worked example – market supply (wheat producers)
Three farms supply wheat as follows (price £/ton, quantity supplied):
| Price (£) | Farm X | Farm Y | Farm Z |
|---|---|---|---|
| 100 | 20 | 15 | 10 |
| 120 | 30 | 25 | 20 |
| 140 | 40 | 35 | 30 |
Market supply = X + Y + Z:
| Price (£) | Market supply |
|---|---|
| 100 | 45 |
| 120 | 75 |
| 140 | 105 |
This horizontal addition gives the market‑supply curve.
Supply curve
Price (P) on the vertical axis, quantity supplied (Qs) on the horizontal axis. The curve slopes upwards because a higher price makes it profitable to produce more.
Movements vs. shifts
- Movement along the curve: caused only by a change in the price of the good itself.
- Shift of the curve: caused by any of the determinants below.
Determinants that shift supply (exam‑frequent)
| Determinant | Effect on supply curve |
|---|---|
| Input prices | Higher input cost → left (decrease) |
| Technology | Improvement → right (increase) |
| Number of sellers | More sellers → right |
| Expectations of future price | Higher expected future price → left now |
| Taxes & subsidies | Tax ↑ → left; Subsidy ↑ → right |
| Prices of related goods (alternative products) | Higher alternative price → right |
2.4 Price determination – equilibrium
The market‑clearing (equilibrium) price is where the quantity demanded equals the quantity supplied. At this point there is no surplus or shortage.
Numeric example
Suppose:
\[
Q_d = 100 - 2P \qquad\text{(demand)}
\]
\[
Q_s = 20 + 3P \qquad\text{(supply)}
\]
Set \(Qd = Qs\) and solve for the equilibrium price \(P^*\):
- \(100 - 2P = 20 + 3P\)
- \(100 - 20 = 3P + 2P\)
- \(80 = 5P\)
- \(P^* = 16\)
Substitute \(P^* = 16\) back into either equation to find the equilibrium quantity:
- \(Q_d = 100 - 2(16) = 68\)
- \(Q_s = 20 + 3(16) = 68\)
Hence the equilibrium is P* = £16 and Q* = 68 units.
Diagram (ceteris paribus)
2.5 How price changes affect the market
| Shift | Effect on price | Effect on quantity | Implication for revenue / expenditure |
|---|---|---|---|
| Demand ↑ (right) | Price ↑ | Quantity ↑ | Consumer expenditure ↑; firms’ total revenue ↑ if demand is inelastic, ↓ if elastic. |
| Demand ↓ (left) | Price ↓ | Quantity ↓ | Consumer expenditure ↓; firms’ revenue ↓ if demand is inelastic, ↑ if elastic. |
| Supply ↑ (right) | Price ↓ | Quantity ↑ | Consumers pay less; firms’ revenue may fall if price falls more than quantity rises. |
| Supply ↓ (left) | Price ↑ | Quantity ↓ | Consumers pay more; firms may earn higher revenue per unit but sell fewer units. |
2.6 Price elasticity of demand (PED)
Definition: PED measures the responsiveness of the quantity demanded to a change in price.
Formula
\[
\text{PED} = \frac{\%\;\text{change in quantity demanded}}{\%\;\text{change in price}}
= \frac{\Delta Q/Q}{\Delta P/P}
\]
Interpretation
- Elastic demand (|PED| > 1) – quantity changes proportionally more than price.
- Inelastic demand (|PED| < 1) – quantity changes proportionally less than price.
- Unitary elastic (|PED| = 1) – total revenue unchanged when price changes.
- Perfectly elastic (|PED| = ∞) – any price rise drives quantity demanded to zero.
- Perfectly inelastic (|PED| = 0) – quantity demanded does not change as price changes.
Determinants of PED (Cambridge focus)
| Determinant | Effect on elasticity |
|---|---|
| Availability of close substitutes | More substitutes → more elastic |
| Proportion of income spent on the good | Higher proportion → more elastic |
| Nature of the good (luxury vs. necessity) | Luxuries → more elastic |
| Time horizon | Longer period → more elastic |
Relevance to total revenue
- If demand is elastic, a price cut raises total revenue; a price rise reduces it.
- If demand is inelastic, a price rise raises total revenue; a price cut reduces it.
2.7 Price elasticity of supply (PES)
Definition: PES measures the responsiveness of the quantity supplied to a change in price.
Formula
\[
\text{PES} = \frac{\%\;\text{change in quantity supplied}}{\%\;\text{change in price}}
= \frac{\Delta Qs/Qs}{\Delta P/P}
\]
Interpretation
- Elastic supply (PES > 1) – output can be increased quickly when price rises.
- Inelastic supply (PES < 1) – output changes little with price.
- Unitary elastic supply (PES = 1) – proportional change.
- Perfectly elastic supply (PES = ∞) – producers will supply any quantity at a given price.
- Perfectly inelastic supply (PES = 0) – quantity supplied cannot change (e.g., fixed‑supply goods).
Determinants of PES (Cambridge focus)
| Determinant | Effect on elasticity |
|---|---|
| Time period | Long run → more elastic (firms can adjust plant size) |
| Availability of inputs | Easier access → more elastic |
| Mobility of factors of production | Higher mobility → more elastic |
| Capacity utilisation | Low utilisation → more elastic |
2.8 Roles of buyers and sellers
Buyers (consumers)
- Create demand through preferences, income, expectations and the number of buyers.
- Signal scarcity or abundance by the maximum price they are willing to pay.
- Allocate resources to the most valued uses by choosing which goods to purchase.
- Provide the profit incentive that encourages firms to innovate, improve quality and reduce costs.
Sellers (producers)
- Offer quantities at various prices, forming the market‑supply curve.
- Base production decisions on marginal cost; they produce up to the point where price = marginal cost.
- Seek profit, which drives efficient allocation of resources.
- Compete on price, quality and innovation, delivering benefits to consumers.
| Aspect | Buyers (Consumers) | Sellers (Producers) |
|---|---|---|
| Primary objective | Maximise utility from limited income | Maximise profit |
| Key decision factor | Preferences, income, price, expectations | Cost of production, technology, price, expected profit |
| Influence on price | Through the demand curve (willingness to pay) | Through the supply curve (costs and willingness to sell) |
| Signal to the other side | Higher willingness to pay → higher price signal | Higher marginal cost → need for a higher price to cover costs |
| Effect of a change | Shift in demand changes equilibrium price & quantity | Shift in supply changes equilibrium price & quantity |
2.9 Summary
The price mechanism answers the three allocation questions by turning buyers’ willingness to pay and sellers’ willingness to produce into a market‑clearing price. Demand reflects consumer preferences and income; supply reflects producers’ costs and technology. Equilibrium is reached where the two curves intersect, and any surplus or shortage creates pressure that moves the price back toward equilibrium. The responsiveness of demand and supply—measured by PED and PES—determines how changes in price affect total revenue, consumer expenditure and the speed of resource re‑allocation. Mastery of these concepts enables students to analyse real‑world market outcomes and to evaluate the efficiency of resource allocation in a market economy.