1.1 Competitive markets: Demand and Supply
1. Outline the meaning of the term market.
A market is a group of buyers and sellers of a particular product.
Free market economies
Markets enable mutually beneficial exchange between producers
and consumers, and systems that rely on markets to solve the
economic problem are called market economies.
In a free market economy, resources are allocated through the
interaction of free and self-directed market forces.
This means that what to produce is determined consumers, how to
produce is determined by producers, and who gets the products
depends upon the purchasing power of consumers.
Market economies work by allowing the direct interaction of
consumers and producers who are pursuing their own self-interest.
The pursuit of self-interest is at the heart of free market economics.
2. Explain the negative (inverse) causal relationship
between price and quantity demanded.
Law of demand: the claim that the quantity demanded
of a good falls when the price of the good rises, other
things equal.
The Law of demand implies a negative or inverse
relationship between the two variables of price and
quantity demanded.
2. Explain the negative (inverse) causal
relationship between price and quantity demanded.
Demand comes from the
behavior of buyers.
The quantity demanded
of any good is the
amount of the good that
buyers are willing and
able to purchase.
Demand schedule:
A table that shows the
relationship between the
price of a good and the
quantity demanded.
2. Explain the negative (inverse) causal relationship
between price and quantity demanded.
Factors that underlie the law of demand:
 The income effect. Real income refers to income that is
adjusted fro price changes, and implies the actual buying
power of a consumer. As the price of a good decreases, the
quantity demanded increases because consumers now have
more real income to spend. With more buying power, they
sometimes choose to buy more of the same product.
 The substitution effect. As the price of a good decreases,
consumers switch from other substitute goods to this good
because its price is comparatively lower.
 The law of diminishing marginal utility. This law states that
as we consume additional units of something, the satisfaction
(utility) we derive for each additional unit (marginal unit)
grows smaller (diminishes).
2. Explain the negative (inverse) causal relationship
between price and quantity demanded.
What’s wrong with this statement?
3. Describe the relationship between an individual
consumer’s demand and market demand.
To get the total market demand for a good we take the
sum of all the individual demand curves for the same
good.
4. Explain how factors including changes in income (in the cases of normal and inferior
goods), preferences, prices of related goods (in the cases of substitutes and
complements) and demographic changes may change demand.
Non-price determinates of demand:
1. Income of buyers
2. Price of related goods
3. Taste and preferences
4. Expectations of future prices and income
5. Number of potential buyers
4. Explain how factors including changes in income (in the cases of normal and
inferior goods), preferences, prices of related goods (in the cases of substitutes
and complements) and demographic changes may change demand.
Non-price determinates of demand:
1. Income
People tend to increase their spending
when their income improves.
 Normal goods
These are goods which demand
increases as income rises and falls as
income falls.
 Inferior goods
These are goods for which demand
decreases as income rises and increases
as income falls. Typically these type of
goods tend to be cheaper alternatives
to higher quality goods.
4. Explain how factors including changes in income (in the cases of normal and
inferior goods), preferences, prices of related goods (in the cases of substitutes
and complements) and demographic changes may change demand.
Non-price determinates of demand:
2. Price of related goods
Substitute goods
These are goods that one might easily use in
place of another. Because they are so similar, an
increase in the price of one may lead consumers
to switch consumption to the substitute. Therefore,
the price of one good and the demand for a
substitute have a positive relationship.
 Complementary goods
These are goods that are typically purchased
and consumed together. Therefore an increase in
the price of a complementary good will appear
to the consumer as an increase in the price of
enjoying the combined experience of both
goods. As a result, the price of one good and
the demand for a complement have a negative
relationship.

4. Explain how factors including changes in income (in the cases of normal and
inferior goods), preferences, prices of related goods (in the cases of substitutes
and complements) and demographic changes may change demand.
Non-price determinates of demand:
3. Taste and preferences
Demand changes with
consumer tastes and
preference.
Goods become more or
less popular because of
fashion, current events, and
word of mouth
recommendations.
4. Explain how factors including changes in income (in the cases of normal and
inferior goods), preferences, prices of related goods (in the cases of substitutes
and complements) and demographic changes may change demand.
Non-price determinates of demand:
4. Expectations of future prices and income
 Expectation of future prices
If consumers believe that price of a good is
likely to climb rather quickly, they will be
inclined to purchase more immediately. An
expectation that prices will decline soon is
likely to cause consumers to defer their
purchases until the product becomes cheaper.
 Expectation of future income
If consumers are buying in an economic climate
of high growth, they may reasonably conclude
that their future incomes will rise, and thus
consume more. This would shift demand right.
The reverse can be true and demand shifts
left.
Expectation of future prices
4. Explain how factors including changes in income (in the cases of normal and inferior
goods), preferences, prices of related goods (in the cases of substitutes and
complements) and demographic changes may change demand.
Non-price determinates of demand:
5. Number of potential buyers
More buyers mean more
demand and a shift to the right
of the demand curve for goods.
Correspondingly, a decrease in
the potential number of buyers
shrink demand.
5. Distinguish between movements along the
demand curve and shifts of the demand curve.
One significant difference
between change in price and
change in the non-price
determinants of demand is that
a change in price will cause only
a movement along the demand
curve.
However, when the non-price
determinants of demand change,
there is a shift of the entire
demand curve. The quantity
demanded will change at each
price.
5. Distinguish between movements along the
demand curve and shifts of the demand curve
6. Draw diagrams to show the difference between movements along the
demand curve and shifts of the demand curve.
7. Explain a demand function (equation) of the form
Qd = a – bP.
Qd represents the quantity demanded: x-axis
a represents the autonomous level of demand or the
quantity demanded if the price were zero: X-intercept
b represents the change in quantity demanded resulting
from a change in price – it is negative, which reflects
the fact that quantity demanded changes inversely with
the price.
P represents the price of a single item.
7. Explain a demand function (equation) of the
form Qd = a – bP.
Intercepts
The x-intercept: This is the point where the demand curve meets the x-axis.
It is the quantity demanded where price equals zero. It is „a‟.
The y-intercept: This is the point where the demand curve meets the y-axis.
It is the price at which quantity demanded becomes zero. All consumers
have been driven out of the market.(a divided by b!)
8. Plot a demand curve from a linear function
(e.g. Qd = 400 – 8P).
How to plot / draw the demand curve from a demand function
(Using the example QD = 400 – 8P)
Follow the steps:
1. Find the quantity demanded when the price is zero. This will be the “a‟
value. In the example, it is 400 units. This gives one point on the demand
curve, known as the x-intercept. In the example, it is the point (400,0), where
400 units are demanded at a price of $0.
2. Find the price where demand is zero. Make QD = 0 in the equation. In
the example, we get 0 = 400 – 8P, and so by adding 8P to each side, we
then get 8P = 400, and so P = 50. This gives a second point at the other
end of the demand curve, known as the Y-intercept. In the example, it is the
point (0,50), where 0 units are demanded at a price of $50. (Or you can
just divide a by b = 400/8 = 50!)
3. So, you now have two points on the demand curve.
8. Plot a demand curve from a linear function
(e.g. Qd = 60 – 5P).
4. Draw your axes for the
market on a piece of graph
paper and insert values for
price and quantity. (In IB
exams, the axes will already
have values on, but not labels. )
5. Insert the two points that
you have calculated. For our
example, this is shown below
left: (0,50), (400,0)
6. Label the axes and the
demand curve. You have done
it!
9. Identify the slope of the demand curve as the slope of the
demand function Qd = a – bP, that is –b (the coefficient of P).
If the value of ”b‟
changes in the
demand function,
then the slope of the
demand curve will
change.
The slope of the
demand curve is
“– b‟.
10. Outline why, if the “a” term changes, there will
be a shift of the demand curve.
If the value of “a‟ in the demand function changes, then the
demand curve shifts to the left or the right, parallel to the
original curve.
If the demand curve shifts to the right, then it means that
there has been a change in one of the non-price
determinants of demand that has made the product more
attractive to the consumer and so more is demanded at each
price.
If the demand curve shifts to the left, then it means that there
has been a change in one of the non-price determinants of
demand that has made the product less attractive to the
consumer and so less is demanded at each price.
10. Outline why, if the “a” term changes, there will
be a shift of the demand curve.
11. Outline how a change in “b” affects the steepness of the
demand curve.
If “b‟ gets smaller,
then the slope of the
curve gets steeper
and if “b”; gets
bigger, the curve will
be flatter.
12. Explain the positive causal relationship between price and
quantity supplied.
Law of supply: the claim that the quantity supplied of
a good rises when the price of the good rises, other
things equal
12. Explain the positive causal relationship between price
and quantity supplied.
Supply comes from the
behavior of sellers.
The quantity supplied of
any good is the amount
that sellers are willing
and able to sell.
Supply schedule:
A table that shows the
relationship between the
price of a good and the
quantity supplied.
12. Explain the positive causal relationship between price and
quantity supplied.
Why is the supply curve upward sloping?
 Market price rises
When the market price rises (for example following an increase in consumer demand), it
becomes more profitable for businesses to increase their output.
Higher prices send signals to firms that they can increase their profits by satisfying demand
in the market.
 The Law of diminishing returns
The law of diminishing marginal returns explains what happens to the output of products
when a firm uses more variable inputs while keeping a least one factor of production fixed.
Real capital, such as buildings, machinery, and equipment, is usually the factor kept fixed
when demonstrating this principle.
Economic theory predicts that, when employing these extra variable factors, such as labor,
the marginal returns (additional output) from each extra unit of input will eventually diminish.
 Diminishing returns and increasing costs
Firms need to sell their extra output at a higher price so that they can pay the higher
marginal cost of production. Hence, decisions to supply are largely determined by the
marginal cost of production. The supply curve slopes upward, reflecting the higher price
needed to cover the higher marginal cost of production. The higher marginal cost arises
because of diminishing marginal returns to the variable factors.
13. Describe the relationship between an individual
producer’s supply and market supply.
The quantity supplied in the market is the sum of
the quantities supplied by all sellers at each price.
14. Explain that a supply curve represents the relationship between the
price and the quantity supplied of a product, ceteris paribus.
A movement along a supply
curve only occurs when the
price changes, ceteris
paribus. In other words, the
price changes but the other
non-price determinants
remain constant.
The diagram shows that a
price rise will cause an
extension up the supply
curve, whilst a price fall will
cause a contraction back
down the supply curve.
14. Explain that a supply curve represents the relationship between the
price and the quantity supplied of a product, ceteris paribus.
As with shifts of demand
curves, supply curves shift,
at all prices, if there is a
change in one or more of
the non-price
determinants of supply.
Nearly all the non-price
determinants of supply
affect the costs of the firm
and, therefore, its supply
curve, which is its marginal
cost curve.
15. Draw a supply curve.
16. Explain how factors including changes in costs of factors of production (land, labor, capital and
entrepreneurship), technology, prices of related goods (joint/competitive supply), expectations,
indirect taxes and subsidies and the number of firms in the market can change supply.
Non-price determinates of supply:
1. Costs of factors of production (Inputs)
2. Changes in production technology
3. Prices of related goods (joint/competitive supply)
4. Expectations
5. Government intervention
6. Number of firms in the market
7. Climatic conditions (weather)
16. Explain how factors including changes in costs of factors of production (land, labor,
capital and entrepreneurship), technology, prices of related goods (joint/competitive supply),
expectations, indirect taxes and subsidies and the number of firms in the market can change
supply.
What causes a shift in the supply curve?
Non-price determinates of supply:
1. Costs of factors of production (Inputs)
A fall in the costs of production leads to an increase in the
supply of a good because the supply curve shifts downwards
and to the right.
Lower costs mean that a business can supply more at each
price.
If production costs increase, a business will not be able to
supply as much at the same price - this will cause an inward
shift of the supply curve.
16. Explain how factors including changes in costs of factors of production (land, labor,
capital and entrepreneurship), technology, prices of related goods (joint/competitive
supply), expectations, indirect taxes and subsidies and the number of firms in the market can
change supply.
Non-price determinates of supply:
2. Changes in production technology
Productivity is the amount of output per unit of input.
If a firm is able to use fewer factor resources in the
production process, it will spend less on those resources.
Technology is what producers know about the ways to
combine inputs into the production of outputs.
An advance in technology makes it possible to sell more of a
good.
A decline in technology means producers can sell less of a
good.
16. Explain how factors including changes in costs of factors of production (land, labor,
capital and entrepreneurship), technology, prices of related goods (joint/competitive
supply), expectations, indirect taxes and subsidies and the number of firms in the market can
change supply.
Non-price determinates of supply:
3. Prices of related goods (joint/competitive supply)
The supply for one good is based on the prices paid for other goods
that use the same resources for production.
A change in the price of a substitute good (or substitute-inproduction) induces sellers to alter the mix of goods purchased.
An increase in the price of a substitute motivates sellers to sell more
of this good and less of the substitute good.
A change in the price of a complement good (or complement-inproduction) induces sellers to supply more or less of both goods.
An increase in the price of a complement motivates sellers to sell
more of this good as they sell more of the complement good.
16. Explain how factors including changes in costs of factors of production (land, labor,
capital and entrepreneurship), technology, prices of related goods (joint/competitive supply),
expectations, indirect taxes and subsidies and the number of firms in the market can
change supply.
Non-price determinates of supply:
4. Expectations
The decision to sell a good today depends on
expectations of future prices.
Sellers seek to sell the good at the highest possible
price.
If sellers expect the price to decline in the future, they
are inclined to sell more now.
If they expect the price to rise in the future, they are
inclined to sell less now.
16. Explain how factors including changes in costs of factors of production (land, labor,
capital and entrepreneurship), technology, prices of related goods (joint/competitive supply),
expectations, indirect taxes and subsidies and the number of firms in the market can
change supply.
Non-price determinates of supply:
5. Government intervention
Government intervention in a market can have a major
effect on supply.
A tax on producers causes an increase in costs and will cause
the supply curve to shift inwards. Less will be supplied after
the tax is introduced.
A subsidy has the opposite effect as a tax. A subsidy will
increase supply because a guaranteed payment from the
Government reduces a firm's costs allowing them to produce
more output at a given price.
16. Explain how factors including changes in costs of factors of production (land, labor,
capital and entrepreneurship), technology, prices of related goods (joint/competitive supply),
expectations, indirect taxes and subsidies and the number of firms in the market can
change supply.
Non-price determinates of supply:
6. Number of firms in the market
The number of sellers in a market will affect total
market supply.
When new firms enter a market, supply increases and
causes downward pressure on the market price.
The entry of new firms into a market causes an
increase in market supply and normally leads to a fall
in the market price paid by consumers.
More firms increases market supply and expands the
range of choice available.
16. Explain how factors including changes in costs of factors of production (land, labor,
capital and entrepreneurship), technology, prices of related goods (joint/competitive supply),
expectations, indirect taxes and subsidies and the number of firms in the market can change
supply.
Non-price determinates of supply:
7. Climatic conditions (weather)
For agricultural commodities such as coffee, fruit and
wheat the climate can exert a great influence on supply.
Favorable weather will produce a bumper harvest and
will increase supply.
Unfavorable weather conditions such as a drought will
lead to a poor harvest and decrease supply.
These unpredictable changes in climate can have a
dramatic effect on market prices for many agricultural
goods.
17. Distinguish between movements along the
supply curve and shifts of the supply curve.
A Change in Supply: This a change in the overall supply
relation, a change in all price-quantity pairs. It is caused
by a change in one of the seven supply non-price
determinants and is indicated by a shift of the supply
curve.
A Change in Quantity Supplied: This is a change in the
specific amount of the good that sellers are willing and
able to purchase. It is caused by a change in the supply
price and is indicated by a movement along the supply
curve from one point to another.
18. Draw diagrams to show the difference between movements along the
supply curve and shifts of the supply curve.
19. Explain a supply function (equation) of the form
Qs = c + dP.
Qs is quantity supplied: x-axis
c is the quantity supplied when price is 0.: y-intercept
d represents the rate which a change in price will cause
the quantity supplied to increase. It is always positive, in
keeping with the law of supply. It is the slope of the
curve
P is the price: y-axis
20. Plot a supply curve from a linear function
(e.g., Qs = 150 + 150 P).
How to plot / draw the supply curve from a supply function
(Using the example QS = 150 + 150P)
Follow the steps:
1. Find the quantity supplied when the price is zero. This will be the “c‟
value. In the example, it is 150 units. This gives one point on the supply curve,
known as the x-intercept. In this case, it is the point (150,0), where 150 units
are supplied at a price of $0. (It might be a point with a negative quantity
and a price of zero, if “c‟ is negative.)
2. Choose a price above zero. (In IB questions, you will be given the range of
price values that you are to consider, so you can choose one of the prices given.)
Put it into the equation instead of P, in order to get a quantity supplied at that
price. In the example, we could choose a price of $1. We get QS = 150 +
(150 x 1) = 150 + 150 = 300. So, you now have another point on the supply
curve, in the example, it is (300,1).
20. Plot a supply curve from a linear function
(e.g., Qs = 150 + 150 P).
3. Draw your axes for the market
on a piece of graph paper and
insert values for price and
quantity. (In IB exams, the axes will
already have values on, but not
labels.)
4. Insert the two points that you
have calculated. For our example,
this is shown below left:
5. Now extend the line upwards.
For our example, this is shown
right.
6. Label the axes and the supply
curve. You have done it!
21. Identify the slope of the supply curve as the slope of the
supply function Qs = c + dP, that is d (the coefficient of P).
22. Outline why, if the “c” term changes,
there will be a shift of the supply curve.
c is the y-intercept, so if that value is changed, the graph either
translates a shift out or in.
 Increases in the intercept value shifts the curve outwards by
the amount of the increase in the intercept.
 Decrease in the intercept value shifts the curve inwards by the
amount of the decrease in the intercept.
23. Outline how a change in “d” affects the
steepness of the supply curve.
Increase in d will make the slope steeper and decrease in
d will make the slope more flat.
 Increases in the slope causes the curve to be steeper.
 decreases in the slope causes the curve to be flatter.
Market equilibrium
24. Explain, using diagrams, how demand and
supply interact to produce market equilibrium.
Consumers and producers react differently to price changes.
Higher prices tend to reduce demand while encouraging supply, and lower
prices increase demand while discouraging supply.
Economic theory suggests that, in a free market there will be a single price
which brings demand and supply into balance, called equilibrium price.
Both parties require the scarce resource that the other has and hence there
is a considerable incentive to engage in an exchange.
For markets to work, an effective flow of information between buyer and
seller is essential.
Market clearing
Equilibrium price is also called market clearing price because at this price
the exact quantity that producers take to market will be bought by
consumers, and there will be nothing ‘left over’.
This is efficient because there is neither an excess of supply and wasted
output, nor a shortage – the market clears efficiently.
24. Explain, using diagrams, how demand and
supply interact to produce market equilibrium.
How is equilibrium established?
At a price higher than
equilibrium, demand will be less
than 500, but supply will be
more than 500 and there will be
an excess of supply in the short
run.
Graphically, we say that demand
contracts inwards along the curve
and supply extends outwards
along the curve.
Both of these changes are called
movements along the demand or
supply curve in response to a
price change.
24. Explain, using diagrams, how demand and
supply interact to produce market equilibrium.
Demand contracts because at the higher price, the income effect and substitution effect
combine to discourage demand, and demand extends at lower prices because the income
and substitution effect combine to encourage demand.
In terms of supply, higher prices encourage supply, given the supplier's expectation of higher
revenue and profits, and hence higher prices reduce the opportunity cost of supplying more.
Lower prices discourage supply because of the increased opportunity cost of supplying
more. The opportunity cost of supply relates to the possible alternative of the factors of
production.
Changes in demand and supply in response to changes in price are referred to as the
signaling and incentive effects of price changes.
If the market is working effectively, with information passing quickly between buyer and
seller, the market will quickly readjust, and the excess demand and supply will be
eliminated.
In the case of excess supply, sellers will be left holding excess stocks, and price will adjust
downwards and supply will be reduced.
In the case of excess demand, sellers will quickly run down their stocks, which will trigger a
rise in price and increased supply.
The more efficiently the market works, the quicker it will readjust to create a stable
equilibrium price.
24. Explain, using diagrams, how demand and supply
interact to produce market equilibrium.
24. Explain, using diagrams, how demand and supply
interact to produce market equilibrium.
SURPLUS:
A condition in the market in which the quantity demanded is
less than the quantity supplied at the existing price.
Because sellers are unable to sell as much of the good as
they want, a surplus generally causes a decrease in the
market price, which then acts to restore equilibrium.
SHORTAGE:
A condition in the market in which the quantity demanded is
greater than the quantity supplied at the existing price.
Because buyers are unable to buy as much of the good as
they want, a shortage generally causes an increase in the
market price, which then acts to restore equilibrium.
25. Analyze, using diagrams and with reference to excess demand or
excess supply, how changes in the determinants of demand and/or
supply result in a new market equilibrium.
Changes in equilibrium
Graphically, changes in the underlying factors that
affect demand and supply will cause shifts in the position
of the demand or supply curve at every price.
Whenever this happens, the original equilibrium price
will no longer equate demand with supply, and price will
adjust to bring about a return to equilibrium.
25. Analyze, using diagrams and with reference to excess demand or
excess supply, how changes in the determinants of demand and/or
supply result in a new market equilibrium.
There are four basic
causes of a price change:
An increase in demand
shifts the demand curve to
the right, and raises price
and output.
This leads to a change in
demand and an increase in
the quantity supplied.
Demand shifts to the right
25. Analyze, using diagrams and with reference to excess demand or
excess supply, how changes in the determinants of demand and/or
supply result in a new market equilibrium.
Demand shifts to the left
A decrease in demand
shifts the demand curve to
the left and reduces price
and output.
This leads to a change in
demand and a decrease in
the quantity supplied.
25. Analyze, using diagrams and with reference to excess demand or
excess supply, how changes in the determinants of demand and/or
supply result in a new market equilibrium
Supply shifts to the right
An increase in supply shifts
the supply curve to the
right, which reduces price
and increases output.
This leads to a change in
supply and a increase in
quantity demanded.
25. Analyze, using diagrams and with reference to excess demand or
excess supply, how changes in the determinants of demand and/or
supply result in a new market equilibrium
Supply shifts to the left
A decrease in supply shifts
the supply curve to the left,
which raises price but
reduces output.
This leads to a change in
supply and a decrease in
quantity demanded.
25. Analyze, using diagrams and with reference to excess demand or excess
supply, how changes in the determinants of demand and/or supply result in
a new market equilibrium
Complex Cases
When demand and supply are
changing at the same time, the analysis
becomes more complex.
In such cases, we are still able to say
whether one of the two variables
(equilibrium price or quantity) will
increase or decrease, but we may not
be able to say how both will change.
When the shifts in demand and supply
are driving price or quantity in
opposite directions, we are unable to
say how one of the two will change
without further information.
26. Calculate the equilibrium price and equilibrium quantity
from linear demand and supply functions. (or Data)
In general, total revenue is
the price times quantity--the
price received for selling a
good times the quantity of the
good sold at that price.
Total expenditure is the total
amount of money that is spent
on a product in a given time
period. This amount is
achieved by multiplying the
quantity of the product
purchased by the price at
which it was purchased.
26. Calculate the equilibrium price and equilibrium quantity
from linear demand and supply functions. (or Data)
Calculating Equilibrium Price and Quantity
In order to do this, we need to find where QD = QS.
The steps are as follows:
1. Take the two functions that you are given and substitute QD
and QS from them into an equilibrium equation.
E.g. QD = 200 – 4P and QS = 4P
So: 200 – 4P = 4P
2. Solve the equation for P and this gives the equilibrium price.
E.g. 200 – 4P = 4P
200 = 8P
200/8 = P
25 = P
26. Calculate the equilibrium price and equilibrium quantity
from linear demand and supply functions. (or Data)
3. Substitute P into either of the demand or supply
functions and solve for Q.
E.g. QD = 200 – 4P
QD = 200 – (4 x 25)
QD = 200 – 100
QD = 100
4. You can check this by solving for Q in the function that
you did not use the first time.
E.g. QS = 4P
QS = 4 x 25
QS = 100
27. Plot demand and supply curves from linear functions,
and identify the equilibrium price and equilibrium quantity.
The equilibrium quantity and the equilibrium price of a product are determined by the point where the supply and demand curves
intersect. For a given product, the supply is determined by the line
Q supply = 30p - 45
and for the same product, the demand is determined by the line
Q demanded = -15p + 855.
Determine the price and the equilibrium quantity and trace the supply and demand curves on the same graph.
Solution :
We must determine the coordinates of point (q,p), situated at the intersection of the two lines. This point must therefore satisfy both
the supply and the demand equations. The solution to this problem is to solve :
Q = 30p - 45
Q = -15p + 855
Thus,
30p - 45 = -15 + 855
45p = 900
P = 20
and
Q = 30(20) – 45 = 555
The equilibrium price and quantity are therefore $20 and 555.
27. Plot demand and supply curves from a table, and
identify the equilibrium price and equilibrium quantity.
Price
QD
QS
$1
100
10
$2
90
40
$3
70
70
$4
40
140
28. Calculate the quantity of excess demand or
excess supply in the above diagrams.
Calculating Excess Demand or Supply
You may be given demand and supply functions and a price that is not the equilibrium
price. You may then be asked to calculate any excess demand or excess supply that exists.
The steps are as follows:
1. Take the price that is given and substitute it into the demand function.
E.g. If the price suggested is $20 and the demand function is QD = 200 – 4P.
Then at $20, QD = 200 – (4 x 20) = 200 – 80 = 120.
2. Then take the price that is given and substitute it into the supply function.
E.g. If the price suggested is $20 and the demand function is QS = 4P.
Then at $20, QS = 4 x 20 = 80.
3. See which one is larger and then explain what it is in terms of either excess demand
or excess supply.
E.g. In this case, at a price of $20, 120 units are demanded and 80 units are supplied
and so there is an excess demand of 40 units.
28. Calculate the quantity of excess demand or
excess supply in the above diagrams.
Calculating Excess Demand or
Supply
You may be given demand and supply
functions and a price that is not the
equilibrium price. You may then be
asked to calculate any total revenue
or total spending that exists.


Calculate the total revenue at
$2.00 ($2 x 40 = $80) and at
$4.00 ($4 x 40 = $160)
Calculate the total spending at
$1.00 ($1 x 10 = $10) and at
$3.00 ($3 x 70 = $210)
28. Calculate the quantity of excess demand or
excess supply in the above diagrams.
350-150 = 200, 200 x .25 = $50
300-200 = 100, 100 x .40 = $40
The role of the price mechanism
Adam Smith, one of the Founding Fathers of economics
described the “invisible hand of the price mechanism”
in which the hidden-hand of the market operating in a
competitive market through the pursuit of self-interest
allocated resources in society’s best interest.
The price mechanism describes the means by which
millions of decisions taken by consumers and businesses
interact to determine the allocation of scarce resources
between competing uses
The price mechanism plays three important functions
in a market:
29. Explain why scarcity necessitates choices that
answer the “What to produce?” question.
Markets answer these basic questions through prices.
For example, resource owners (those producing goods) decide
What? goods to produce based on relative prices.
Prices work much the same way for answering the How? question.
Producers decide which resources to use in the production of a good,
based on relative prices.
Prices are also the guiding light when markets answer the For
Whom? question.
In this case, the relative prices paid to labor and other resource
owners for the production of different goods are the key.
Resource owners paid relatively higher prices receive relatively
more income, which they can use to purchase relatively more goods.
30. Explain why choice results in an
opportunity cost.
Due to scarcity, each choice we make requires us to
sacrifice or give something up. Opportunity cost is the
highest value trade-off--the value of the next best
option foregone.
31. Explain, using diagrams, that price has a signaling function and an incentive
function, which result in a reallocation of resources when prices change as a result of a
change in demand or supply conditions.
The rationing function of the price mechanism
Whenever resources are particularly scarce, demand
exceeds supply and prices are driven up.
The effect of such a price rise is to discourage demand and
conserve resources.
The greater the scarcity, the higher the price and the more
the resource is rationed.
This can be seen in the market for oil. As oil slowly runs out,
its price will rise, and this discourages demand and leads to
more oil being conserved than at lower prices.
The rationing function of a price rise is associated with a
contraction of demand along the demand curve.
31. Explain, using diagrams, that price has a signaling function and an incentive
function, which result in a reallocation of resources when prices change as a result of a
change in demand or supply conditions.
The signaling function of the price mechanism
Price changes send contrasting messages to consumers and producers
about whether to enter or leave a market.
Rising prices give a signal to consumers to reduce demand or withdraw
from a market completely, and they give a signal to potential producers
to enter a market.
Conversely, falling prices give a positive message to consumers to enter a
market while sending a negative signal to producers to leave a market.
For example, a rise in the market price of 'smart' phones sends a signal to
potential manufacturers to enter this market, and perhaps leave another
one.
The signaling function is associated with shifts in demand and supply
curves.
31. Explain, using diagrams, that price has a signaling function and an incentive
function, which result in a reallocation of resources when prices change as a result of a
change in demand or supply conditions.
The incentive function of the price mechanism
An incentive is something that motivates a producer or
consumer to follow a course of action or to change
behavior.
Higher prices provide an incentive to existing producers
to supply more because they provide the possibility or
more revenue and increased profits.
The incentive function of a price rise is associated with
an extension of supply along the existing supply curve.
31. Explain, using diagrams, that price has a signaling function and an
incentive function, which result in a reallocation of resources when prices
change as a result of a change in demand or supply conditions.
Market efficiency
An allocation of resources is efficient if it maximizes total surplus.
Efficiency means:
 Raising or lowering the quantity of a good would not increase
total surplus.
 The goods are being produced by the producers with lowest cost.



The goods are being consumed by the buyers who value them
most highly.
Efficiency means making the pie as big as possible.
In contrast, equity refers to whether the pie is
divided fairly.
32. Explain the concept of consumer surplus.
Consumer surplus is derived whenever the price a
consumer actually pays is less than they are prepared to
pay.
A demand curve indicates what price consumers are
prepared to pay for a hypothetical quantity of a good,
based on their expectation of private benefit.
Consumer surplus (CS) is the amount a buyer is willing
to pay minus the buyer actually pays:
CS = WTP – P
33. Identify consumer surplus on a demand and
supply diagram.
For example, at price P, the total
private benefit in terms of utility
derived by consumers from consuming
quantity, Q is shown as the area ABQC
in the diagram.
The amount consumers actually spend is
determined by the market price they
pay, P, and the quantity they buy, Q namely, P x Q, or area PBQC.
This means that there is a net gain to
the consumer, because area ABQC is
greater that area PBQC.
This net gain is called consumer surplus,
which is the total benefit, area ABQC,
less the amount spent, area PBQC.
Hence ABQC - PBQC = area ABP.
CS with Lots of Buyers & a Smooth D Curve
P
CS is the area b/w P
and the D curve, from
0 to Q.
Recall: area of
a triangle equals
½ x base x height
Height of
this triangle is
$60 – 30 = $30.
So,
CS = ½ x (15 x $30)
= $225.
The demand for shoes
$ 60
50
h
40
30
20
10
D
Q
0
0
5 10 15 20 25 30
How a Higher Price Reduces CS
P
If P rises to $40,
CS = ½ x (10 x $20)
= $100.
Two reasons for the fall
in CS.
2. Fall in CS due to
remaining buyers
paying higher P
60
50
1. Fall in CS
due to buyers
leaving market
40
30
20
10
D
Q
0
0
5 10 15 20 25 30
34. Explain the concept of producer surplus.
Producer surplus is the additional private benefit to
producers, in terms of profit, gained when the price they
receive in the market is more than the minimum they
would be prepared to supply for.
In other words they received a reward that more than
covers their costs of production.
Producer surplus (PS): the amount a seller
is paid for a good minus the seller’s cost.
35. Identify producer surplus on a
demand and supply diagram.
The producer surplus
derived by all firms in the
market is the area from the
supply curve to the price
line, EPB.
The producer surplus is
the area above the market
supply curve and below
the market price.
PS with Lots of Sellers & a Smooth S Curve
P
The supply of shoes
60
PS is the area b/w
P and the S curve, from 50
0 to Q.
40
The height of this
30
triangle is
h
$40 – 15 = $25.
20
So,
10
PS = ½ x b x h
= ½ x 25 x $25
0
= $312.5
S
Q
0
5 10 15 20 25 30
How a Lower Price Reduces PS
P
If P falls to $30,
PS = ½ x 15 x $15
= $112.5
Two reasons for the
fall in PS.
2. Fall in PS due to
remaining sellers
getting lower P
60
50
1. Fall in PS
due to sellers
leaving market
S
40
30
20
10
Q
0
0
5 10 15 20 25 30
36. Evaluate the view that the best allocation of resources from society’s point of view is at
competitive market equilibrium, where social (community) surplus (consumer surplus and
producer surplus) is maximized (marginal benefit = marginal cost).
Economic welfare is the total
benefit available to society from
an economic transaction or
situation.
Economic welfare is also called
community surplus.
Welfare is represented by the
area ABE in the diagram beside,
which is made up of the area for
consumer surplus, ABP plus the
area for producer surplus, PBE.
In market analysis economic
welfare at equilibrium can be
calculated by adding consumer
and producer surplus.
Evaluating the Market Equilibrium
P
Market eq’m:
P = $30
Q = 15,000
Total surplus
= CS + PS
Is the market eq’m
efficient?
Calculate the area of
CS, PS and Total
Surplus.
60
S
50
40
CS
30
PS
20
10
D
Q
0
0
5 10 15 20 25 30
Which Buyers Get to Consume the Good?
P
Every buyer
whose WTP is
≥ $30 will buy.
Every buyer
whose WTP is
< $30 will not.
So, the buyers who
value the good most
highly are the ones
who consume it.
60
S
50
40
30
20
10
D
Q
0
0
5 10 15 20 25 30
Which Sellers Produce the Good?
P
Every seller whose cost
is ≤ $30 will produce
the good.
Every seller whose cost
is > $30 will not.
Hence, the sellers with
the lowest cost
produce the good.
60
S
50
40
30
20
10
D
Q
0
0
5 10 15 20 25 30
Does Eq’m Q Maximize Total Surplus?
P
At Q = 20,
cost of producing
the marginal unit
is $35
value to consumers
of the marginal unit
is only $20
Hence, can increase total
surplus
by reducing Q.
This is true at any Q
greater than 15.
60
S
50
40
30
20
10
D
Q
0
0
5 10 15 20 25 30
Does Eq’m Q Maximize Total Surplus?
At Q = 10,
cost of producing
the marginal unit
is $25
value to consumers
of the marginal unit
is $40
P
60
S
50
40
30
Hence, can increase total
20
surplus
by increasing Q.
10
This is true at any Q less
than 15.
D
Q
0
0
5 10 15 20 25 30
Evaluating the Market Eq’m: Summary
The market equilibrium is efficient:
 The
equilibrium Q maximizes total surplus.
 The goods are produced by the producers with lowest
cost,
 and consumed by the buyers who value them most highly.
The government cannot improve on the market outcome.
Laissez faire (French for “allow them to do”):
the government should not interfere with the market.