The price system and the microeconomy (AS)

2.1 Demand and supply curves

Demand

Demand is the quantity of a good that consumers are willing and able to buy at each price in a given period. The law of demand: as price falls, quantity demanded rises (ceteris paribus), so the demand curve slopes down.

A change in the price causes a movement along the demand curve (an extension or contraction). A change in a non-price factor shifts the curve:

• Income (normal goods rise, inferior goods fall)
• Prices of related goods: substitutes (a rise in the price of one increases demand for the other) and complements (a rise reduces demand for the other)
• Tastes and fashion, advertising
• Population size and structure
• Expectations of future prices and incomes
• Interest rates and credit availability, taxation of income

Reasons for the downward slope: the income effect (a lower price raises real income), the substitution effect (the good becomes cheaper relative to others) and diminishing marginal utility.

Supply

Supply is the quantity producers are willing and able to sell at each price. The law of supply: as price rises, quantity supplied rises, so the supply curve slopes up (higher price means higher profit and covers higher marginal costs).

A price change moves along the supply curve; a non-price factor shifts it:

• Costs of production (wages, raw materials, energy)
• Technology
• Indirect taxes (shift left) and subsidies (shift right)
• Prices of other goods that producers could make (joint and competitive supply)
• Number of firms in the market
• Weather and natural events, expectations

2.2 Price elasticity, income elasticity and cross elasticity of demand

Price elasticity of demand (PED)

$\text{PED}=\frac{\%\Delta Q_d}{\%\Delta P}$

Example: price rises from $10 to $12 (+20%), quantity falls from 500 to 450 (−10%). PED = −10 ÷ 20 = −0.5: inelastic.

Determinants: availability and closeness of substitutes, necessity or luxury, the proportion of income spent, the time period (more elastic in the long run), and addiction and brand loyalty.

PED and total revenue: if demand is elastic, a price rise lowers revenue; if inelastic, a price rise raises revenue. Firms use PED to set prices; governments use it to judge the effect of indirect taxes (taxing a good with inelastic demand raises more revenue and cuts consumption less).

Income elasticity of demand (YED)

$\text{YED}=\frac{\%\Delta Q_d}{\%\Delta \text{income}}$

Positive for normal goods (above 1 for luxuries, between 0 and 1 for necessities) and negative for inferior goods. Importance: shows how demand responds to the economic cycle and the long-term trend as incomes grow, which guides investment decisions.

Cross elasticity of demand (XED)

$\text{XED}=\frac{\%\Delta Q_d\text{ of good A}}{\%\Delta P\text{ of good B}}$

Positive for substitutes (the bigger the value, the closer the substitute) and negative for complements. Firms use XED to predict the effect of rivals' price changes.

Along a straight-line demand curve, PED varies: it is elastic at high prices (the top left, where a small quantity is bought), unitary at the midpoint and inelastic at low prices (the bottom right), because the same absolute change is a bigger percentage of a small number. PED and total expenditure (revenue): if demand is elastic, a price rise reduces total expenditure; if inelastic, it raises it; at unit elasticity it is unchanged. A price cut has the opposite effect.

2.3 Price elasticity of supply

Determinants: spare capacity, stocks of finished goods, ease of switching production, time (more elastic in the long run), availability of inputs and the mobility of factors. Perishable and agricultural goods have inelastic short-run supply, so prices are volatile.

The sign of PES is positive; its size shows how responsive supply is: a larger coefficient means a greater percentage change in quantity supplied for the same percentage price change. Relative percentage changes matter, not absolute ones. Elastic supply means firms react quickly and easily to new market conditions; inelastic supply means they take time (for example when capacity, skills or land are limited).

2.4 The interaction of demand and supply

Equilibrium price is where quantity demanded equals quantity supplied; there is no tendency to change.

• Excess demand (a shortage): price is below equilibrium, so price rises until the market clears.
• Excess supply (a surplus): price is above equilibrium, so price falls.

Changes in equilibrium: an increase in demand (shift right) raises price and quantity; a decrease in supply (shift left) raises price and cuts quantity. A change in both needs analysis of relative sizes of the shifts.

Price mechanism functions: signalling, rationing and allocating. Applications: commodity markets, housing, labour, the effect of indirect taxes and subsidies.

Equilibrium is where quantity demanded equals quantity supplied; disequilibrium is any other price, with a shortage or surplus. Markets are linked: joint demand (complements such as printers and ink: a fall in one price raises demand for the other), alternative demand (substitutes such as tea and coffee), derived demand (the demand for a factor such as steel depends on the demand for cars) and joint supply (producing one good gives another, such as beef and leather: a rise in demand for beef increases the supply of leather).

The functions of price in allocating resources are rationing (high prices limit demand when goods are scarce), signalling (prices transmit consumers' preferences to producers, who move resources to goods in high demand) and incentivising (higher prices encourage firms to produce more and consumers to economise). Effective demand is demand backed by the ability to pay, not just a want.

2.5 Consumer and producer surplus

• Consumer surplus is the difference between what consumers are willing to pay and the price they actually pay: the area under the demand curve and above the price.
• Producer surplus is the difference between the price received and the minimum price the producer would accept: the area above the supply curve and below the price.

Changes in price alter surplus: a fall in price raises consumer surplus; a rise cuts it. Total (economic) surplus is the sum; it is maximised at the free-market equilibrium (allocative efficiency, when no externalities). Government intervention or market failure can reduce total surplus (deadweight loss).

The extent to which surplus changes when price changes depends on elasticity: when demand is inelastic, a price rise takes a larger fall in consumer surplus and gives producers more revenue; when supply is inelastic, a price change moves producer surplus by more.