Cambridge O Level2281

Price determination

Economics 2281 Chapter Notes

What this chapter covers

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

  1. 1Market Equilibrium: Where Demand Meets Supply
  2. 2Market Disequilibrium: Shortages and Surpluses
  3. 3Shifts in Demand and Supply
  4. 4Government Intervention and Pricing
  5. 5Business Pricing Strategies

1. Market Equilibrium: Where Demand Meets Supply

In any market, buyers (demand) and sellers (supply) have opposing interests: buyers want low prices, and sellers want high prices. The market finds a balance at the 'equilibrium price'. This is the specific price where the quantity of a good that consumers are willing and able to buy is exactly equal to the quantity that producers are willing and able to sell. At this point, the market is 'cleared' because there are no leftover products (surplus) and no unsatisfied customers (shortage). We can find this equilibrium point either by looking at a demand and supply schedule (a table) or by finding where the demand and supply curves intersect on a graph.

Key term

Equilibrium Price: The price at which the quantity demanded by consumers equals the quantity supplied by producers, resulting in a stable market.

Examiner insight

Examiners award marks for correctly identifying both the equilibrium price and the equilibrium quantity from a table or a graph.

Common pitfall

Simply stating that equilibrium is 'where demand equals supply'. A precise answer states that it is where the 'quantity demanded' equals the 'quantity supplied' at a specific price.

Worked example 14 marks

The table below shows the market demand and supply for packets of crisps per week.

Price ($)Quantity DemandedQuantity Supplied
0.501000200
0.60800400
0.70600600
0.80400800
0.902001000

a) What is the equilibrium price and quantity? (2 marks)b) If the price was set at $0.80, what would be the situation in the market? (2 marks)

  1. 1

    a) To find the equilibrium, look for the price where Quantity Demanded equals Quantity Supplied.

  2. 2

    In the table, at a price of $0.70, both the quantity demanded and the quantity supplied are 600 packets.

  3. 3

    Therefore, the equilibrium price is $0.70 and the equilibrium quantity is 600 packets.

  4. 4

    b) At a price of $0.80, the Quantity Demanded is 400 packets, but the Quantity Supplied is 800 packets.

  5. 5

    Since supply (800) is greater than demand (400), there is an excess supply, also known as a surplus, of 800 - 400 = 400 packets.

Recap

  • Equilibrium is the point where the demand curve and supply curve intersect.
  • The equilibrium price is the price where quantity demanded equals quantity supplied.
  • The equilibrium quantity is the amount bought and sold at the equilibrium price.
  • At equilibrium, the market is said to 'clear'.
  • You can identify equilibrium from a schedule or a graph.

Quick check

  1. Define the term 'equilibrium quantity'.2 marks
  2. If quantity demanded is 500 and quantity supplied is 300, is the market in equilibrium?1 mark

2. Market Disequilibrium: Shortages and Surpluses

When the market price is not at the equilibrium level, we have a state of 'disequilibrium'. This results in either an excess demand or an excess supply.

Excess Demand (Shortage): This occurs when the price is set *below* the equilibrium price. At this lower price, consumers demand more of the good than producers are willing to supply. This creates a shortage. In a free market, this shortage puts upward pressure on the price as consumers compete for the limited goods, pushing the price back towards equilibrium.

Excess Supply (Surplus): This occurs when the price is set *above* the equilibrium price. At this higher price, producers supply more of the good than consumers are willing to buy. This creates a surplus of unsold goods. To get rid of this surplus, producers will lower their prices, which moves the market back towards equilibrium.

Excess Demand (Shortage) = Quantity Demanded - Quantity Supplied (when price is below equilibrium)

Excess Supply (Surplus) = Quantity Supplied - Quantity Demanded (when price is above equilibrium)

Key term

Disequilibrium: A situation in a market where the quantity demanded does not equal the quantity supplied, resulting in either a shortage or a surplus.

Examiner insight

Marks are often awarded for correctly calculating the numerical value of the shortage or surplus, not just for identifying its existence.

Worked example 13 marks

Using the demand and supply schedule for crisps from the previous section, calculate the size of the disequilibrium at a price of $0.50 and state whether it is a surplus or a shortage.

  1. 1
    1. Identify the quantities at the given price of $0.50.
  2. 2

    From the table, at $0.50, Quantity Demanded = 1000 packets.

  3. 3

    From the table, at $0.50, Quantity Supplied = 200 packets.

  4. 4
    1. Compare the quantities.
  5. 5

    Quantity Demanded (1000) is greater than Quantity Supplied (200). This means there is an excess demand (a shortage).

  6. 6
    1. Calculate the size of the shortage.
  7. 7

    Shortage = Quantity Demanded - Quantity Supplied = 1000 - 200 = 800 packets.

Recap

  • Disequilibrium occurs when the market price is not the equilibrium price.
  • A price below equilibrium causes excess demand (a shortage).
  • A price above equilibrium causes excess supply (a surplus).
  • Market forces (the 'price mechanism') naturally push prices back towards equilibrium.
  • Shortages cause prices to rise; surpluses cause prices to fall.

Quick check

  1. If there is a surplus of a product, what will happen to its price?1 mark
  2. What is another name for excess demand?1 mark

3. Shifts in Demand and Supply

The market equilibrium is not static; it changes when the conditions of demand or supply change. These changes are shown as shifts in the demand or supply curves.

A shift in the Demand Curve: Caused by a change in a non-price factor affecting demand (e.g., consumer income, tastes, price of substitutes/complements). An increase in demand shifts the curve to the right, leading to a higher equilibrium price and quantity. A decrease in demand shifts the curve to the left, leading to a lower equilibrium price and quantity.

A shift in the Supply Curve: Caused by a change in a non-price factor affecting supply (e.g., costs of production, technology, weather). An increase in supply shifts the curve to the right, leading to a lower equilibrium price and a higher quantity. A decrease in supply shifts the curve to the left, leading to a higher equilibrium price and a lower quantity.

Key term

Shift in Demand/Supply: A change in the quantity demanded or supplied at every price, caused by a change in a non-price factor, represented by a movement of the entire curve.

Examiner insight

Examiners look for clearly labelled diagrams showing the original and new curves, and the original and new equilibrium points. You must explicitly state what happens to both price and quantity in your conclusion.

Common pitfall

Confusing a 'shift of the curve' with a 'movement along the curve'. A change in the product's own price causes a movement along the curve, while a change in any other factor causes a shift.

Worked example 14 marks

The market for ice cream is in equilibrium. A heatwave causes more people to want to buy ice cream. Using a demand and supply diagram, analyse the effect on the equilibrium price and quantity of ice cream.

  1. 1
    1. Draw a standard demand and supply diagram. Label the axes 'Price' and 'Quantity', the curves 'D1' and 'S', and the initial equilibrium 'P1' and 'Q1'.
  2. 2
    1. The heatwave increases consumer taste for ice cream, which is a condition of demand. This causes the demand curve to shift to the right, from D1 to a new position, D2.
  3. 3
    1. The supply curve (S) does not change.
  4. 4
    1. The new equilibrium is where the new demand curve (D2) intersects the supply curve (S). Label this new equilibrium P2 and Q2.
  5. 5
    1. Conclude by observing the change: The new equilibrium price (P2) is higher than the original price (P1), and the new equilibrium quantity (Q2) is higher than the original quantity (Q1).

Worked example 24 marks

The market for cars is in equilibrium. The cost of steel, a key component in car manufacturing, rises significantly. Explain the effect on the equilibrium price and quantity of cars.

  1. 1
    1. An increase in the cost of steel raises the costs of production for car manufacturers.
  2. 2
    1. This makes it less profitable to supply cars at any given price, causing a decrease in supply.
  3. 3
    1. The supply curve for cars shifts to the left (e.g., from S1 to S2).
  4. 4
    1. Assuming demand remains constant, the new equilibrium point occurs at a higher price and a lower quantity.
  5. 5
    1. Therefore, the equilibrium price of cars will rise, and the equilibrium quantity of cars sold will fall.

Recap

  • A change in a non-price factor shifts the entire demand or supply 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. If a new technology makes producing smartphones cheaper, which curve shifts and in which direction?2 marks

4. Government Intervention and Pricing

Governments can influence market outcomes by imposing indirect taxes or providing subsidies.

Indirect Taxes: These are taxes levied on goods and services, such as Value Added Tax (VAT) or excise duties. A tax increases the costs of production for the supplier. This causes the supply curve to shift to the left (or upwards by the amount of the tax). The result is a higher market price for consumers and a lower quantity traded. The price increase is usually less than the full amount of the tax, meaning the tax burden is shared between consumers (paying a higher price) and producers (receiving less revenue per unit).

Subsidies: A subsidy is a payment from the government to a producer to lower their costs and encourage production. A subsidy shifts the supply curve to the right. This results in a lower market price for consumers and a higher quantity traded. It is effectively the opposite of a tax.

Key term

Subsidy: A payment made by a government to producers to reduce their costs of production and encourage them to increase output.

Examiner insight

When analysing a tax or subsidy, clearly state that the supply curve shifts. For a tax, the new price will be higher but not by the full tax amount. For a subsidy, the new price will be lower but not by the full subsidy amount.

Worked example 15 marks

The equilibrium price of a bicycle is $200. The government decides to grant producers a subsidy of $30 per bicycle. Using a demand and supply diagram, analyse the likely effect on the market price and quantity of bicycles sold.

  1. 1
    1. Draw a standard demand and supply diagram, showing the initial equilibrium at P1 ($200) and Q1.
  2. 2
    1. A subsidy reduces the costs of production for firms. This will increase supply.
  3. 3
    1. The supply curve shifts to the right, from S1 to a new position, S2.
  4. 4
    1. The new equilibrium is where the demand curve (D) intersects the new supply curve (S2). Label this P2 and Q2.
  5. 5
    1. The diagram shows that the new equilibrium price (P2) is lower than $200, and the new equilibrium quantity (Q2) is higher than Q1.
  6. 6
    1. Conclusion: The subsidy leads to a fall in the market price of bicycles and an increase in the quantity sold.

Recap

  • An indirect tax on a product increases production costs and shifts the supply curve left.
  • A tax leads to a higher equilibrium price and a lower equilibrium quantity.
  • A subsidy for a product decreases production costs and shifts the supply curve right.
  • A subsidy leads to a lower equilibrium price and a higher equilibrium quantity.
  • Taxes raise revenue for the government, while subsidies are a cost to the government.

Quick check

  1. What is an example of an indirect tax?1 mark
  2. Does a subsidy cause the market price to rise or fall?1 mark

5. Business Pricing Strategies

Firms don't just let the market decide the price; they use specific strategies to achieve their objectives, such as profit maximisation or gaining market share. The choice of strategy depends on the product, market competition, costs, and business goals.

Cost-Plus Pricing: This is a straightforward method where the firm calculates the average cost of producing a single unit and then adds a percentage 'mark-up' for profit. For example, if a cake costs $5 to make and the firm wants a 50% mark-up, the price will be $5 + (50% of $5) = $7.50. It's simple but ignores consumer demand and competitors' prices.

Price Skimming: Used for new, innovative products with little competition (like a new smartphone model). The firm sets a high initial price to 'skim' the maximum revenue from early adopters willing to pay more. The price is then lowered over time as competitors enter the market.

Penetration Pricing: The opposite of skimming. A firm sets a very low price when entering a competitive market to attract customers and gain market share quickly. The goal is to build a customer base, after which the price may be raised. This is common in markets like telecoms and streaming services.

Cost-Plus Price = Average Cost per unit + (% Mark-up × Average Cost per unit)

Key term

Penetration Pricing: Setting a low initial price for a new product to attract a large number of buyers quickly and gain a high market share.

Common pitfall

Mixing up price skimming and penetration pricing. Remember: Skimming starts high (like skimming cream off the top), while Penetration starts low (to 'penetrate' or enter the market).

Fun fact

When the first ballpoint pens were introduced in 1945, they used price skimming, selling for $12.50 each – the equivalent of over $200 today!

Worked example 13 marks

A furniture company produces 100 identical tables at a total cost of $8,000. It wants to use cost-plus pricing with a 40% mark-up for profit. Calculate the selling price of one table.

  1. 1
    1. Calculate the average cost per unit.
  2. 2

    Average Cost = Total Cost / Total Output = $8,000 / 100 tables = $80 per table.

  3. 3
    1. Calculate the mark-up amount.
  4. 4

    Mark-up = 40% of $80 = 0.40 × $80 = $32.

  5. 5
    1. Add the mark-up to the average cost to find the selling price.
  6. 6

    Selling Price = Average Cost + Mark-up = $80 + $32 = $112.

Recap

  • Pricing strategies are plans for setting a product's price.
  • Cost-plus pricing involves adding a profit mark-up to the average cost of production.
  • Price skimming sets a high initial price for a new product and lowers it later.
  • Penetration pricing sets a low initial price to gain market share.
  • The choice of strategy depends on factors like competition, costs, and objectives.

Quick check

  1. Which pricing strategy is most suitable for a revolutionary new games console with no direct competitors at launch?1 mark
  2. A T-shirt costs $4 to produce. If a firm uses a 100% mark-up, what is the selling price?1 mark

End-of-chapter exercise

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

  1. Define 'market equilibrium' and explain how a market moves from a position of excess supply back to equilibrium.4 marks
  2. A firm makes watches at an average cost of $50 per unit. It uses cost-plus pricing to set its price, adding a 60% mark-up. Calculate the price of a watch.2 marks
  3. Explain, using a demand and supply diagram, how an increase in consumer incomes might affect the market for foreign holidays.5 marks
  4. Distinguish between price skimming and penetration pricing, giving an example of a product for which each strategy might be suitable.4 marks
  5. Analyse the impact of a government subsidy on the producers of solar panels. Refer to price, quantity, and producer revenue in your answer.6 marks
  6. The market for coffee is in equilibrium. A widespread frost damages a large portion of the world's coffee bean crop. At the same time, a new health report is published stating that drinking coffee reduces the risk of some diseases. Analyse the effect on the equilibrium price and quantity of coffee.8 marks
  7. Explain two reasons why a government might impose an indirect tax on a product like petrol.4 marks
  8. Using a demand and supply diagram, show the effect of a successful advertising campaign for a brand of chocolate on its market price and quantity sold.4 marks
  9. Consider the market for smartphones. Explain how a fall in the price of a substitute product, such as a different brand's smartphone, would affect the equilibrium.4 marks
  10. A mobile phone company is the 10th firm to enter a crowded market. Its main objective is to gain a 5% market share within one year. Discuss the pricing strategy it is likely to adopt and explain the reasons for this choice.6 marks

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