This is the core of microeconomics: how markets decide what is produced and who gets it, what happens when they fail, and how governments respond.
2.1 The role of markets in allocating resources
- A market is any place or system where buyers and sellers meet to trade goods, services or resources (face to face or online).
- Examples: a fruit market, a stock exchange, an online shopping site, the labour market (workers sell their labour to firms) and the foreign exchange market.
- Buyers (consumers) create demand: they decide what to buy to get the most satisfaction. Sellers (producers) create supply: they decide what to sell to make a profit.
The interaction of buyers and sellers sets prices and decides how scarce resources are allocated.
2.2 Demand
- Individual demand is the demand of one consumer. Market demand is the sum of all individual demands for the good at each price.
- The law of demand: as price falls, quantity demanded rises (and the reverse), other things being equal. This gives a downward-sloping demand curve.
Drawing the demand curve
Put price on the vertical axis and quantity on the horizontal axis. The demand curve slopes downwards from left to right, labelled D.
Movement along the curve (extension and contraction)
A change in the good's own price causes a movement along the same demand curve:
- price falls → extension (quantity demanded rises, move down the curve)
- price rises → contraction (quantity demanded falls, move up the curve)
Shifts of the curve
A change in any other factor shifts the whole curve:
- Increase in demand: the curve shifts right (more at every price).
- Decrease in demand: the curve shifts left.
Causes of a shift (remember PIRATES): Population (size, age), Income (for a normal good, higher income increases demand), Related goods (substitutes: a rise in the price of tea raises the demand for coffee; complements: a rise in the price of cars lowers demand for petrol), Advertising, Tastes and fashion, Expectations (of future prices), Seasons.
2.3 Supply
- Individual supply is one firm's supply; market supply is the sum of all firms' supplies.
- Law of supply: as price rises, quantity supplied rises (higher price means more profit per unit), giving an upward-sloping supply curve (S).
Movements along the curve
Own price rises → extension of supply; price falls → contraction.
Shifts
- Increase in supply: shift right. Decrease: shift left.
Causes of a shift: costs of production (wages, raw materials, energy: lower costs increase supply), technology (new technology lowers costs and raises supply), government policy (a subsidy increases supply; a tax decreases it), weather (for farm goods), number of firms, prices of related goods (a firm may switch production), and expectations.
2.4 Price determination
The price mechanism
The price mechanism allocates resources through changes in prices, answering the three questions:
- What to produce: goods with high demand have high prices and profits, so firms produce more of them; goods in low demand are produced less.
- How to produce: firms choose the cheapest method (the lowest cost) to keep profits high.
- For whom to produce: goods go to those who are willing and able to pay (who have the income).
Market equilibrium
| Price ($) | Quantity demanded | Quantity supplied |
|---|---|---|
| 10 | 500 | 100 |
| 20 | 400 | 200 |
| 30 | 300 | 300 |
| 40 | 200 | 400 |
| 50 | 100 | 500 |
Here the equilibrium price is $30 and the equilibrium quantity is 300.
Disequilibrium
Disequilibrium is when quantity demanded does not equal quantity supplied.
- Shortage (excess demand): price below equilibrium: demand exceeds supply (at $20 in the table: 400 − 200 = 200 shortage). Price tends to rise.
- Surplus (excess supply): price above equilibrium: supply exceeds demand (at $40: 400 − 200 = 200 surplus). Price tends to fall.
On a diagram, a price line below the crossing shows the shortage as the horizontal gap between D and S; a line above shows the surplus.
2.5 Price changes
Causes
Price changes when demand or supply shifts and the market finds a new equilibrium:
| Change | Effect on price | Effect on quantity |
|---|---|---|
| Demand increases (D shifts right) | rises | rises |
| Demand decreases (D shifts left) | falls | falls |
| Supply increases (S shifts right) | falls | rises |
| Supply decreases (S shifts left) | rises | falls |
Consequences of price changes
Price changes affect sales: a higher price tends to reduce quantity sold (and a lower price to increase it), and change revenue (see elasticity). They also send signals: a rising price encourages firms to produce more and consumers to buy less.
Using diagrams
To show a change: draw D and S with the original equilibrium E₁; shift the curve that has changed (label the new curve D₂ or S₂); mark the new equilibrium E₂; read off the new price P₂ and quantity Q₂, and say what happened. Always label axes and curves.
2.6 Price elasticity of demand (PED)
PED = % change in quantity demanded ÷ % change in price
Interpreting the value (ignoring the sign)
| PED value | Description | Meaning |
|---|---|---|
| 0 | perfectly inelastic | quantity does not change at all when price changes |
| between 0 and 1 | inelastic | quantity changes by a smaller percentage than price |
| = 1 | unitary | quantity changes by the same percentage as price |
| greater than 1 | elastic | quantity changes by a larger percentage than price |
| infinity | perfectly elastic | any price rise makes demand fall to zero |
On a diagram: perfectly inelastic = a vertical line; inelastic = a steep curve; elastic = a flat (shallow) curve; perfectly elastic = a horizontal line.
Determinants of PED
- Availability of substitutes: many substitutes = elastic; few = inelastic.
- Necessity or luxury: necessities (salt, medicine) are inelastic; luxuries are elastic.
- Proportion of income spent: a small share of income = inelastic; a large share = elastic.
- Time: demand is more elastic over time as consumers find alternatives.
- Addiction/habit (cigarettes) = inelastic.
PED, spending and revenue
Total revenue = price × quantity.
| If demand is… | A price rise | A price fall |
|---|---|---|
| Elastic (PED > 1) | revenue falls (quantity falls proportionately more) | revenue rises |
| Inelastic (PED < 1) | revenue rises | revenue falls |
| Unitary (PED = 1) | no change | no change |
The same applies to consumer expenditure (what consumers spend).
Significance of PED
- Firms: if demand is inelastic, they can raise prices and increase revenue; if elastic, lowering the price may raise revenue.
- Governments: taxes on goods with inelastic demand (fuel, tobacco) raise a lot of revenue and reduce quantity only slightly.
- Consumers: need to know that a price rise on a necessity will affect their budget.
- Workers: demand for labour may be elastic or inelastic, which affects whether higher wages cause job losses.
2.7 Price elasticity of supply (PES)
PES = % change in quantity supplied ÷ % change in price
Interpreting the value works the same way: 0 = perfectly inelastic (vertical line), < 1 = inelastic, = 1 = unitary, > 1 = elastic, infinity = perfectly elastic (horizontal line).
Determinants of PES:
- Spare capacity: with unused capacity, supply is more elastic.
- Stocks of finished goods: large stocks make supply elastic.
- Time: supply is more elastic over time; farm goods are inelastic in the short run (growing takes months).
- Availability and mobility of factors of production: if labour and materials are easy to obtain, supply is elastic.
- Ease of production (manufactured goods are usually more elastic than farm goods or goods that need a long training).
2.8 Market economic system
A market economic system is one in which resources are allocated by the price mechanism (the forces of demand and supply), with private ownership and little government involvement.
| Advantages | Disadvantages |
|---|---|
| consumer sovereignty: firms produce what consumers want | market failure: no public goods, external costs ignored |
| efficient: competition keeps costs and prices low | inequality: wide gaps between rich and poor |
| choice and quality | monopoly power may develop |
| incentive to work, invest and innovate (profit) | merit goods (education, healthcare) under-provided and demerit goods over-consumed |
| quick response to changing demand | unemployment in downturns |
2.9 Market failure
Key terms
| Term | Meaning |
|---|---|
| Private benefit/cost | the benefit gained or cost paid by the consumer or producer directly involved |
| External benefit/cost | the benefit or cost to third parties (people not involved in the transaction) |
| Social benefit/cost | private + external |
| Public goods | non-excludable (cannot stop people using them) and non-rival (one person's use does not reduce another's); examples: street lighting, national defence, flood barriers |
| Merit goods | goods the government thinks are good for people, which would be under-consumed if left to the market (education, healthcare, vaccination) |
| Demerit goods | goods that are harmful and tend to be over-consumed (cigarettes, alcohol, drugs) |
| Monopoly | a single firm (or one that has most of the market) |
Causes of market failure
- Public goods: because people can free-ride (use without paying), private firms will not supply them, so government must provide them.
- Merit goods: consumers do not realise the full benefits (or cannot afford them), so there is under-consumption.
- Demerit goods: consumers ignore the harm (to themselves and others), so there is over-consumption.
- External costs (pollution from a factory): the price does not include the cost to society, so too much is produced.
- External benefits (education, vaccination): the price does not reflect benefits to others, so too little is produced.
- Abuse of monopoly power: a monopoly can restrict output and raise prices, and have little reason to improve quality.
Consequences of market failure
- Over-consumption of demerit goods and goods with external costs.
- Under-consumption of merit goods and goods with external benefits.
- Non-provision of public goods.
- Higher prices and restricted supply under a monopoly.
(Demand and supply diagrams for market failure are not required.)
2.10 Mixed economic system
A mixed economic system is one in which both the private sector and the government allocate resources: the market works for most goods, and the government provides some goods and services, regulates and redistributes.
| Advantages | Disadvantages |
|---|---|
| corrects market failure (public goods, merit goods, external costs) | government failure: errors, inefficiency, bureaucracy |
| more equal income through taxes and benefits | higher taxes and lower incentives |
| protects consumers and workers | the state may be slower and less responsive to consumers |
| keeps competition and choice | cost of intervention, risk of corruption |
Government intervention
| Measure | What it is | Effect | Advantages | Disadvantages |
|---|---|---|---|---|
| Maximum price (price ceiling) | a legal limit on a price, below equilibrium (rent control, price of staple foods) | makes the good more affordable, but creates a shortage (demand > supply) | helps low-income buyers | shortages, black markets, firms cut quality |
| Minimum price (price floor) | a legal minimum above equilibrium (minimum wage, farm support prices, minimum alcohol price) | protects producers' or workers' income; creates a surplus | higher income for suppliers | surplus, higher cost to buyers, unemployment (if a wage) |
| Indirect tax (VAT, tax on tobacco) | a tax on spending that raises costs, shifting supply left | raises price and cuts quantity; raises government revenue, discourages demerit goods | raises revenue, reduces consumption of harmful goods | regressive (hits the poor), may cause inflation, black markets, depends on PED |
| Subsidy | payment to producers that lowers their costs, shifting supply right | lowers price and raises quantity | encourages merit goods and green products | costs the government (opportunity cost), may support inefficient firms |
| Regulation | laws and rules controlling business behaviour (pollution limits, safety standards) | reduces harm | protects consumers and the environment | costs for firms, enforcement is difficult |
| Privatisation | selling state-owned firms to the private sector | competition and efficiency may improve; raises revenue | profit motive, efficiency | loss of public services for the poor, may create a private monopoly, job losses |
| Nationalisation | the government takes over a private firm | protects essential services, avoids private monopoly | prevents abuse of power | inefficiency, cost, lack of incentive |
| Direct provision | the government provides goods (schools, hospitals, roads) | ensures everyone gets them | equal access, funded by tax | high cost, waiting lists, may be inefficient |
| Quotas (e.g. on resource extraction) | a limit on the quantity (fish catch, quantity of oil that can be extracted) | conserves resources | protects the environment | may raise price, hard to enforce, reduces firms' output |
Diagrams: maximum price: draw D and S; draw a horizontal line below equilibrium; the gap between D and S at that price is the shortage. Minimum price: a horizontal line above equilibrium; the gap is the surplus. Indirect tax: S shifts up/left to S + tax; the price rises and the quantity falls. Subsidy: S shifts down/right; the price falls and the quantity rises.
Practise this chapter
Every past-paper question on these topics, with the mark scheme.
- 2.1The role of markets in allocating resources3 questions
- 2.2Demand23 questions
- 2.3Supply15 questions
- 2.4Price determination15 questions
- 2.5Price changes28 questions
- 2.6Price elasticity of demand (PED)27 questions
- 2.7Price elasticity of supply (PES)18 questions
- 2.8Market economic system19 questions
- 2.9Market failure39 questions
- 2.10Mixed economic system34 questions