Shortages (demand exceeding supply) and surpluses (supply exceeding demand)

Allocation of Resources – Price Determination (Cambridge 2.4)

1. The Price Mechanism

Definition (Cambridge 2.4.1): The price mechanism is the process by which the forces of demand and supply interact in a market to allocate resources and to determine the price at which the quantity demanded equals the quantity supplied.

2. Key Concepts

• Demand (Q_d): quantity of a good that consumers are willing and able to buy at each possible price.
• Supply (Q_s): quantity of a good that producers are willing and able to sell at each possible price.
• Market equilibrium (Cambridge 2.4.2): the point where Q_d = Q_s. At this point the market “clears” – there is no tendency for the price to change.
• Equilibrium price (P_e) and equilibrium quantity (Q_e): the price and quantity at the equilibrium point.
• Shortage: Q_d > Q_s at a given price (price below P_e).
• Surplus: Q_s > Q_d at a given price (price above P_e).

3. How Shortages and Surpluses Arise

When the market price is not at the equilibrium level, either a shortage or a surplus will develop, creating a pressure for the price to move toward P_e.

1. Price set above equilibrium (P > P_e)

   • Q_s > Q_d → Surplus.
   • Producers have excess stock and will tend to lower the price to clear the surplus.

2. Price set below equilibrium (P < P_e)

   • Q_d > Q_s → Shortage.
   • Consumers cannot obtain enough of the good; they will bid the price up.

4. Graphical Illustration (What you must be able to draw and label)

5. Linear Demand and Supply Functions (Mathematical representation)

Demand:  Qd = a – bP

Supply:  Qs = c + dP

where a, b, c, d are positive constants.

At equilibrium:

a – bPe = c + dPe

Solving for the equilibrium price:

Pe = (a – c) / (b + d)

6. Consequences of Shortages

• Rationing (first‑come‑first‑served, coupons, queues, or other non‑price allocation).
• Black‑market activity.
• Consumers may switch to close substitutes.
• Higher marginal revenue for producers → incentive to increase output.

7. Consequences of Surpluses

• Unsold inventory and higher storage costs.
• Producers may cut output, lay off workers, or reduce investment.
• Downward pressure on price, moving the market back toward equilibrium.
• Possible government intervention (price floors, purchases of excess stock, storage schemes).

8. Supply‑and‑Demand Schedule Example

9. How Markets Self‑Correct

• Shortage: upward pressure on price reduces Q_d and encourages producers to increase output → movement toward equilibrium.
• Surplus: downward pressure on price increases Q_d and reduces output → movement toward equilibrium.

Price Changes – Causes and Consequences (Cambridge 2.5)

1. What causes a price change?

A change in market price occurs only when either the demand curve or the supply curve shifts.

• Demand shift (right‑ward = increase, left‑ward = decrease) → price moves up or down.
• Supply shift (right‑ward = increase, left‑ward = decrease) → price moves down or up.

Thus, “price changes are caused by changes in demand and supply” – exactly as the syllabus states.

2. Shift of the Demand Curve

• Right‑ward (increase): consumers want more of the good at every price (e.g., rise in income for a normal good, larger population, favourable tastes).
• Left‑ward (decrease): the opposite occurs (e.g., fall in income for a normal good, unfavourable tastes).

3. Shift of the Supply Curve

• Right‑ward (increase): producers can supply more at each price (e.g., lower input costs, technological improvement, entry of new firms).
• Left‑ward (decrease): production becomes more costly or fewer firms operate (e.g., higher input prices, stricter regulations).

4. Consequences for Sales Revenue

• Sales revenue (total revenue) = P × Q.
• The direction of change depends on the price elasticity of demand (see Section 2.6).
• When a curve shifts, the new equilibrium price and quantity determine the revenue outcome.

Price Elasticity of Demand (PED) – Cambridge 2.6

1. Definition & Formula

2. Interpretation – Elasticity Ranges

3. The Three Extreme Cases

• Perfectly inelastic demand (PED = 0): quantity demanded does not change regardless of price (e.g., life‑saving insulin for a patient who cannot do without it).
• Unitary elasticity (|PED| = 1): the percentage change in quantity demanded exactly matches the percentage change in price; total revenue is unchanged.
• Perfectly elastic demand (|PED| = ∞): consumers will buy any amount at one price but none if the price rises even slightly (e.g., a commodity sold in a perfectly competitive market where sellers are price‑takers).

4. Determinants of PED (Cambridge 2.6.3)

• Availability of close substitutes – more substitutes → higher elasticity.
• Proportion of income spent on the good – larger share → higher elasticity.
• Time period considered – demand is more elastic in the long run because consumers have time to find alternatives.

5. Impact on Revenue & Consumer Expenditure

• If demand is elastic, a price rise reduces total revenue; consumer expenditure falls.
• If demand is inelastic, a price rise increases total revenue; consumer expenditure rises.
• If demand is unit elastic, total revenue is unchanged.

6. Worked Example

Price of a mobile‑phone case rises from \$10 to \$12 (a 20 % increase). Quantity demanded falls from 500 units to 425 units (a 15 % decrease).

\$\text{PED} = \frac{-15\%}{+20\%} = -0.75\$

Interpretation:

• Absolute value < 1 → demand is inelastic.
• Because demand is inelastic, the 20 % price rise increases total revenue for the seller.
• Consumer expenditure also rises (price up, quantity falls only slightly).

Price Elasticity of Supply (PES) – Cambridge 2.7

1. Definition & Formula

2. Determinants of PES

• Availability of inputs – if inputs are abundant, supply is more elastic.
• Time period – supply is more elastic in the long run because firms can adjust plant size, enter/exit the market, or adopt new technology.
• Spare productive capacity – firms with excess capacity can increase output quickly, making supply more elastic.
• Flexibility of production techniques – more flexible processes → higher PES.

3. Example

Suppose the price of wheat rises from \$200 to \$250 per tonne (a 25 % increase) and the quantity supplied rises from 1 000 000 t to 1 250 000 t (a 25 % increase).

\$\text{PES} = \frac{+25\%}{+25\%} = 1\$

Supply is unit elastic in this case.

Market Economic System (Cambridge 2.8)

Definition

A market (or free‑market) economic system is one in which the allocation of resources and the distribution of output are primarily decided by the price mechanism – i.e., by the interaction of buyers and sellers in markets without central government direction.

Advantages

• Efficient allocation of resources (goods go to those who value them most).
• Encourages innovation and entrepreneurship.
• Consumers have a wide choice of goods and services.
• Prices provide information about scarcity.

Disadvantages

• Can lead to inequality of income and wealth.
• May produce market failures (public goods, externalities, monopolies).
• Short‑term focus on profit can ignore social or environmental costs.
• Not all goods and services are supplied in adequate quantities (e.g., health care, education).

Market Failure (Cambridge 2.9)

1. Public, Merit and Demerit Goods

• Public goods – non‑rival and non‑excludable (e.g., street lighting). Markets under‑provide them because firms cannot charge each user.
• Merit goods – socially desirable but under‑consumed (e.g., vaccinations). Government may subsidise or provide them.
• Demerit goods – socially undesirable and over‑consumed (e.g., cigarettes). Government may tax or restrict them.

2. Externalities

• Negative externality – a cost imposed on third parties (e.g., pollution from a factory). Leads to over‑production.
• Positive externality – a benefit enjoyed by third parties (e.g., a well‑maintained garden improving neighbourhood property values). Leads to under‑production.

3. Monopoly

• A single firm is the sole supplier of a product with no close substitutes.
• Monopolies can set price above marginal cost, creating a dead‑weight loss and a permanent surplus (unsold consumer surplus).

Mixed Economic System (Cambridge 2.10)

Definition

A mixed economic system combines features of a market economy with government intervention. The market determines most prices and outputs, but the state intervenes to correct market failures, provide public goods, and achieve social objectives.

Arguments for a Mixed System

• Corrects market failures (e.g., taxes on pollution, subsidies for education).
• Provides a safety net and reduces extreme inequality.
• Ensures the supply of merit goods and the control of demerit goods.

Arguments against a Mixed System

• Government intervention can distort price signals, leading to inefficiency.
• Risk of bureaucracy, corruption, or political misuse of resources.
• Excessive regulation may stifle innovation and entrepreneurship.

Typical Government Tools

• Price floors (e.g., minimum wage) – set a minimum legal price above the equilibrium price.
• Price ceilings (e.g., rent control) – set a maximum legal price below the equilibrium price.
• Taxes – raise the price of demerit goods or generate revenue to fund public services.
• Subsidies – lower the price of merit goods or encourage production of socially desirable outputs.
• Regulation – standards for safety, environmental protection, or quality.
• Direct provision – government produces or purchases goods (e.g., NHS, public transport).

Key Points to Remember

1. Market equilibrium occurs where Q_d = Q_s. It is the result of the price mechanism.
2. A price above equilibrium creates a surplus; a price below equilibrium creates a shortage.
3. Price adjustments (upward or downward) act as signals that move the market back toward equilibrium.
4. Price changes are caused by shifts in demand or supply – not by movement along the curves alone.
5. Price elasticity of demand (PED) shows how quantity demanded responds to price changes; it determines the revenue effect of a price change.
6. Price elasticity of supply (PES) shows how quantity supplied responds to price changes; it is influenced by input availability, time, and spare capacity.
7. Market failures (public/merit/demerit goods, externalities, monopoly) justify government intervention.
8. A mixed economic system blends market allocation with state intervention to achieve efficiency and equity.
9. Government tools (price floors/ceilings, taxes, subsidies, regulation) can correct disequilibrium but may also create new inefficiencies.