Cambridge IGCSE0455

Price determination

Economics 0455 Chapter Notes

What this chapter covers

Price determination - Price mechanismPrice determination - Market equilibriumPrice determination - Market disequilibrium
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In this chapter

  1. 1Demand, Supply, and Market Equilibrium
  2. 2Finding the Equilibrium Price
  3. 3Market Disequilibrium: Shortages and Surpluses
  4. 4Changes in Market Equilibrium
  5. 5Government Intervention: Taxes and Subsidies

1. Demand, Supply, and Market Equilibrium

In any free market, the price of a good or service is not set by a single buyer or seller, but by the interaction of all buyers and sellers. The 'demand' curve shows how much consumers are willing to buy at different prices, while the 'supply' curve shows how much producers are willing to sell. The point where these two forces meet is called equilibrium. At this point, the quantity consumers want to buy is exactly equal to the quantity producers want to sell. This is the market-clearing price, and as long as conditions don't change, the price will tend to stay there.

Key term

Equilibrium: A state of balance in a market where the quantity demanded equals the quantity supplied, resulting in a stable market price.

Examiner insight

Examiners reward clear, accurately labelled diagrams. Always label your axes (Price, Quantity), your curves (D, S), and the equilibrium price (Pe) and quantity (Qe).

Worked example 14 marks

Using a demand and supply diagram, illustrate and explain the concept of market equilibrium. [4 marks]

  1. 1

    Step 1: Draw a diagram with Price on the vertical (Y) axis and Quantity on the horizontal (X) axis. Label both axes.

  2. 2

    Step 2: Draw a downward-sloping demand curve and label it 'D'. Draw an upward-sloping supply curve and label it 'S'.

  3. 3

    Step 3: Mark the point where the D and S curves intersect. This is the equilibrium point.

  4. 4

    Step 4: Draw a dashed line from the intersection point to the Price axis and label it 'Pe' (Equilibrium Price). Draw another dashed line to the Quantity axis and label it 'Qe' (Equilibrium Quantity). Explain that at price Pe, the quantity demanded (Qe) equals the quantity supplied (Qe), so the market is in equilibrium.

Recap

  • The demand curve slopes downwards, showing an inverse relationship between price and quantity demanded.
  • The supply curve slopes upwards, showing a positive relationship between price and quantity supplied.
  • Market equilibrium occurs where the demand and supply curves intersect.
  • The equilibrium price is the price at which quantity demanded equals quantity supplied.
  • At equilibrium, the market is 'cleared' and there is no tendency for the price to change.

Quick check

  1. What is the relationship between price and quantity demanded?1 mark
  2. At the equilibrium point, what can be said about the quantity demanded and quantity supplied?1 mark

2. Finding the Equilibrium Price

We can find the equilibrium price and quantity in two main ways: using a schedule (a table of data) or by plotting the data on a graph. The schedule shows the quantity demanded and quantity supplied at various prices. To find the equilibrium, we simply look for the price where the quantity demanded and quantity supplied are the same. On a graph, the equilibrium is found at the visual intersection of the demand and supply curves. The price level of this intersection is the equilibrium price, and the quantity level is the equilibrium quantity.

At Equilibrium: Quantity Demanded (Qd) = Quantity Supplied (Qs)

Key term

Market Schedule: A table showing the quantity of a good that consumers are willing to buy (demand) and producers are willing to sell (supply) at a series of different prices.

Common pitfall

When reading from a schedule, students sometimes mix up the quantity demanded and quantity supplied columns, leading to an incorrect analysis.

Worked example 15 marks

The table below shows the market for chocolate bars.a) What is the equilibrium price and quantity?b) If the price was 40 cents, what would be the situation in the market?

Price (cents)Qd (000s)Qs (000s)
50100420
40150300
30200200
20260120
  1. 1

    a) Step 1: Look down the Qd and Qs columns to find the row where the values are equal.

  2. 2

    a) Step 2: At a price of 30 cents, the quantity demanded is 200,000 and the quantity supplied is also 200,000.

  3. 3

    a) Step 3: Therefore, the equilibrium price is 30 cents and the equilibrium quantity is 200,000 chocolate bars.

  4. 4

    b) Step 1: At a price of 40 cents, the quantity demanded is 150,000.

  5. 5

    b) Step 2: At the same price of 40 cents, the quantity supplied is 300,000.

  6. 6

    b) Step 3: Since quantity supplied (300k) is greater than quantity demanded (150k), there is an excess supply (or surplus) of 150,000 chocolate bars.

Recap

  • Equilibrium can be found using a data schedule or a graph.
  • In a schedule, equilibrium is the price where Qd equals Qs.
  • On a graph, equilibrium is where the demand and supply curves cross.
  • The equilibrium price is also known as the market-clearing price.

Quick check

  1. If Qd = 500 and Qs = 500, is the market in equilibrium?1 mark

3. Market Disequilibrium: Shortages and Surpluses

When the market price is not at equilibrium, we have a state of 'disequilibrium'. This results in either a shortage or a surplus. A shortage (or excess demand) occurs when the price is set below equilibrium; more people want to buy the good than producers are willing to sell. This puts upward pressure on the price. A surplus (or excess supply) occurs when the price is set above equilibrium; producers are willing to sell more than consumers are willing to buy. This puts downward pressure on the price. These price movements act as signals that guide the market back towards equilibrium.

Excess Demand (Shortage): Qd > Qs

Excess Supply (Surplus): Qs > Qd

Key term

Price Mechanism: The process by which the forces of supply and demand interact to determine market prices, which in turn allocate scarce resources.

Examiner insight

Students who can explain *how* a surplus or shortage is eliminated through price changes (the incentive for firms and reaction of consumers), rather than just identifying it, score higher marks.

Worked example 14 marks

Using the chocolate bar data from the previous example,a) identify the size of the excess demand at a price of 20 cents, andb) explain how the market would return to equilibrium. [4 marks]

  1. 1

    a) Step 1: At a price of 20 cents, find the quantity demanded and quantity supplied from the schedule. Qd = 260,000 and Qs = 120,000.

  2. 2

    a) Step 2: Calculate the difference: Excess Demand = Qd - Qs = 260,000 - 120,000 = 140,000 bars.

  3. 3

    b) Step 1: Explain that with a shortage, consumers will be willing to pay more to get the limited goods. Producers see this and are incentivised by the potential for higher profit.

  4. 4

    b) Step 2: As a result, producers will raise their prices. As price rises, quantity demanded contracts and quantity supplied expands, eliminating the shortage until the market reaches the equilibrium price of 30 cents.

Recap

  • A price below equilibrium causes a shortage (excess demand).
  • A price above equilibrium causes a surplus (excess supply).
  • Shortages cause prices to rise.
  • Surpluses cause prices to fall.
  • The price mechanism automatically pushes the market back towards equilibrium.

Quick check

  1. What is another name for excess supply?1 mark
  2. If a shop has lots of unsold stock, is the price likely to be above or below equilibrium?1 mark

4. Changes in Market Equilibrium

Equilibrium is not fixed forever. It changes whenever there is a 'shift' in either the demand or supply curve. A shift is caused by a change in any non-price factor. For example, an increase in consumer incomes might increase demand for restaurant meals, shifting the demand curve to the right. This creates a new, higher equilibrium price and quantity. Conversely, a new technology that lowers production costs would shift the supply curve to the right, leading to a new, lower equilibrium price and a higher quantity. Analysing these shifts is a core skill in economics.

Key term

Shift in Demand/Supply: A change in a non-price factor that causes the entire demand or supply curve to move to a new position on the graph, establishing a new equilibrium.

Common pitfall

The most common error is confusing a 'shift' of a curve with a 'movement along' it. Remember: only a change in the product's own price causes a movement along the curve.

Fun fact

When the viral 'TikTok Feta Pasta' recipe trended in 2021, many grocery stores reported selling out of feta cheese, a real-world example of a sudden, taste-driven shift in demand leading to shortages.

Worked example 16 marks

The market for electric cars is initially in equilibrium. A successful government advertising campaign highlights their environmental benefits. Using a diagram, analyse the effect on the equilibrium price and quantity of electric cars. [6 marks]

  1. 1

    Step 1: Draw an initial equilibrium diagram for electric cars, showing D1, S, and the equilibrium point (P1, Q1).

  2. 2

    Step 2: Explain that the advertising campaign changes consumer tastes and preferences, which is a condition of demand.

  3. 3

    Step 3: This causes the demand curve to shift to the right, from D1 to D2.

  4. 4

    Step 4: At the original price P1, there is now an excess demand (shortage). This puts upward pressure on the price.

  5. 5

    Step 5: Show the new equilibrium where D2 intersects S. Label the new equilibrium price P2 and quantity Q2.

  6. 6

    Step 6: Conclude that the equilibrium price and equilibrium quantity of electric cars have both increased (P2 > P1, Q2 > Q1).

Recap

  • A change in a non-price factor causes a shift in a curve.
  • A change in price causes a movement along a curve.
  • An increase in demand (rightward shift) leads to a higher price and higher quantity.
  • A decrease in demand (leftward shift) leads to a lower price and lower quantity.
  • An increase in supply (rightward shift) leads to a lower price and higher quantity.
  • A decrease in supply (leftward shift) leads to a higher price and lower quantity.

Quick check

  1. A rise in the cost of steel shifts which curve for cars, and in which direction?2 marks

5. Government Intervention: Taxes and Subsidies

Governments can influence market prices and quantities through taxes and subsidies. An indirect tax (like VAT or an excise duty) is a tax on a good or service. It increases production costs for the firm, which is shown as a leftward (or upward) shift of the supply curve. This results in a higher market price and a lower quantity traded. A subsidy is a payment from the government to a producer. It lowers production costs, shifting the supply curve to the right. This results in a lower market price and a higher quantity traded. Governments use these tools to discourage consumption of some goods (e.g., cigarettes) and encourage consumption of others (e.g., renewable energy).

Key term

Indirect Tax: A tax levied on goods and services which increases producers' costs and shifts the supply curve to the left.

Examiner insight

For tax and subsidy questions, examiners look for diagrams that clearly show the parallel shift in the supply curve and the resulting new equilibrium price and quantity.

Worked example 16 marks

The government decides to grant a subsidy to producers of solar panels to encourage their use. With the aid of a diagram, analyse the effect on the market price and quantity of solar panels. [6 marks]

  1. 1

    Step 1: Draw a standard demand and supply diagram, labelling the initial equilibrium price P1 and quantity Q1 at the intersection of D and S1.

  2. 2

    Step 2: Explain that a subsidy is a payment to producers that lowers their costs of production.

  3. 3

    Step 3: This causes the supply curve to shift to the right, from S1 to S2.

  4. 4

    Step 4: At the original price P1, there is now an excess supply (surplus), which puts downward pressure on the price.

  5. 5

    Step 5: Show the new equilibrium point where D intersects S2. Label the new, lower equilibrium price P2 and the new, higher equilibrium quantity Q2.

  6. 6

    Step 6: Conclude that the subsidy leads to a fall in the market price of solar panels and an increase in the quantity bought and sold.

Recap

  • An indirect tax increases costs and shifts the supply curve left.
  • A tax leads to a higher price and lower quantity.
  • A subsidy decreases costs and shifts the supply curve right.
  • A subsidy leads to a lower price and higher quantity.
  • Governments use taxes to raise revenue and discourage consumption of demerit goods.
  • Governments use subsidies to encourage production and consumption of merit goods.

Quick check

  1. What is the effect of an indirect tax on the equilibrium price?1 mark
  2. What is the effect of a subsidy on the equilibrium quantity?1 mark

End-of-chapter exercise

Test yourself on the whole chapter. Work through these before moving on.

  1. Define 'equilibrium price' and 'equilibrium quantity'.2 marks
  2. Explain, using an example, two factors that could cause the demand curve for a product to shift to the right.4 marks
  3. Distinguish between a 'movement along the supply curve' and a 'shift in the supply curve'.4 marks
  4. Explain how the price mechanism works to eliminate a market shortage (excess demand).4 marks
  5. Using a demand and supply diagram, analyse the effect of a significant increase in the cost of jet fuel on the market for air travel.6 marks
  6. Using a demand and supply diagram, analyse the impact of a government subsidy on the market for electric bicycles.6 marks
  7. A market for coffee has a demand schedule of Qd = 200 - 5P and a supply schedule of Qs = 50 + 10P, where P is the price in dollars. Calculate the equilibrium price and quantity.4 marks
  8. The invention of a new, more efficient production process for smartphones coincides with a rise in average consumer incomes. Analyse the likely overall effect on the equilibrium price and quantity of smartphones. [Hint: Consider the relative size of the shifts].8 marks
  9. ‘The price of housing is rising because of high demand. Therefore, the government should put a price ceiling on rent to make it affordable.’ Discuss the likely consequences of such a policy.8 marks
  10. Explain how the imposition of an indirect tax on a product affects the price paid by consumers, the revenue received by producers, and the quantity traded in the market.6 marks

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