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.
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 |
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 |
When both curves move, the direction of change in price and quantity depends on the relative magnitude of the shifts.
| 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) |
A per‑unit tax on producers shifts the supply curve upward (or leftward) by the amount of the tax.
A per‑unit subsidy to producers shifts the supply curve downward (or rightward) by the amount of the subsidy.
When price changes, three related variables are affected:
Example – Luxury good (elastic demand)
Example – Necessity (inelastic demand)
These calculations are the basis for answering “what happens to consumer spending/firm revenue when price changes?” – a common Paper 2 command.
PED measures the responsiveness of quantity demanded to a change in price.
\[
\text{PED} = \frac{\%\Delta Q_d}{\%\Delta P}
\]
\[
\text{PED}_{\text{mid}} =
\frac{\displaystyle \frac{Q2 - Q1}{(Q1+Q2)/2}}
{\displaystyle \frac{P2 - P1}{(P1+P2)/2}}
\]
This formula gives the same elasticity regardless of the direction of the price change.
| 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 |
| 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 |
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.
PES measures the responsiveness of quantity supplied to a change in price.
\[
\text{PES} = \frac{\%\Delta Q_s}{\%\Delta P}
\]
\[
\text{PES}_{\text{mid}} =
\frac{\displaystyle \frac{Q{s2} - Q{s1}}{(Q{s1}+Q{s2})/2}}
{\displaystyle \frac{P2 - P1}{(P1+P2)/2}}
\]
| 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) |
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.
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. |
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. |
| 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) |
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