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Edexcel A Level Economics A Your notes

1.2 How Markets Work

Contents
Rational Decision Making
Demand
Price, Income & Cross Elasticities of Demand
Supply
Elasticity of Supply
Price Determination
Price Mechanism
Producer & Consumer Surplus
Indirect Taxes & Subsidies
Alternative Views of Consumer Behaviour

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Rational Decision Making

Your notes
Rational Decision Making
When analysing markets, a range of assumptions are made about the rationality of economic agents
involved in the transactions
In classical economic theory, the word 'rational' means that economic agents are able to consider the
outcome of their choices and recognise the net benefits of each one. Rational agents will select the
choice which presents the highest benefits
Consumers are assumed to act rationally. They do this by maximising their utility
Producers are assumed to act rationally. They do this by selling goods/services in a way that
maximises their profits
Workers are assumed to act rationally. They do this by balancing welfare at work with
consideration of both pay and benefits
Governments are assumed to act rationally. They do this by placing the interests of the people
they serve first in order to maximise their welfare
In many ways, the assumption of rational decision making is flawed. For example, consumers are
often more influenced by emotional purchasing decisions than a rational computation of net benefits

Examiner Tips and Tricks

In your examinations, the data-response and essay questions test your ability to think critically. The
command words for these questions are evaluate, discuss, assess, or examine.
One way in which you can demonstrate critical thinking is to challenge the underlying assumptions
of economic theory. The idea of rational decision making is one such assumption. Do consumers
act rationally when they make impulse purchases? Do workers act rationally when they accept
terrible working conditions for mediocre pay? Do governments actually maximise public welfare or
do they implement policies that mainly benefit their core voter base?
Irrationality distorts markets and produces fundamentally different outcomes than what would be
achieved if all economic agents acted rationally.

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Demand
Your notes
Demand
Demand is the amount of a good/service that a consumer is willing and able to purchase at a given
price in a given time period
If a consumer is willing to purchase a good, but cannot afford to, it is not effective demand
A demand curve is a graphical representation of the price and quantity demanded (QD) by
consumers
If data were plotted, it would be an actual curve; however, economists simplify curves in their
sketches into straight lines to make analysis easier

Movements along a demand curve

If price is the only factor that changes (ceteris paribus), there will be a change in the QD
This change is shown by a movement along the demand curve

A demand curve showing a contraction in quantity demanded (QD) as prices increase and an extension
in quantity demanded (QD) as prices decrease

Diagram analysis
An increase in price from £10 to £15 leads to a movement up the demand curve from point A to B

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Due to the increase in price, the QD has fallen from 10 to 7 units

This movement is called a contraction in QD Your notes
A decrease in price from £10 to £5 leads to a movement down the demand curve from point A to point
C
Due to the decrease in price, the QD has increased from 10 to 15 units
This movement is called an extension in QD
The law of demand captures this fundamental relationship between price and QD
It states that there is an inverse relationship between price and QD
When price rises, the QD falls
When prices fall, QD rises
This relationship partly explains why the demand curve is downward sloping
Conditions of Demand
Shifts of the entire demand curve
There are numerous factors that will change the demand for a good/service, irrespective of the price
level. Collectively, these factors are called the conditions of demand
Changes to each of the conditions of demand shift the entire demand curve (as opposed to a
movement along the demand curve)

A graph that shows how changes to any of the conditions of demand shifts the entire demand curve left
or right, irrespective of the price level
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For example, if a firm increases their Instagram advertising, there will be an increase in demand as
more consumers become aware of the product
Your notes
This is a shift in demand from D to D1. The price remains unchanged at £7 but the demand has
increased from 15 to 25 units
An Explanation of How Each of the Conditions of Demand Shifts the Entire Demand Curve at Every Price
Level

Condition Explanation Condition Shift Condition Shift

Changes in Real Real Income determines Income D Shifts Income D Shifts

Income how many goods/services Increases Right Decreases Left
can be enjoyed by (D→D1) (D→D2)
consumers
There is a direct relationship
between income and
demand for normal goods

Changes in If goods/services become Good D Shifts Good D

taste/fashion more fashionable then becomes Right becomes Shifts
demand for them increases more (D→D1) less Left
fashionable fashionable (D→D2)
There is a direct
relationship between
changes in taste/fashion
and demand

Advertising/ If more money is spent on Advertising D Shifts Advertising D

branding advertising or branding, Increases Right Decreases Shifts
then demand for (D→D1) Left
goods/services will (D→D2)
increase as more
consumers are aware of the
product
There is a direct relationship
between
branding/advertising and
demand

Changes in the Changes in the price of Price of D for Price of D for

prices of substitute goods will Good A Good B Good A Good B

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substitute goods influence the demand for a Increases Shifts Decreases Shifts
product/service Right Left
There is a direct (D→D1) (D→D2) Your notes
relationship between the
price of good A and
demand for good B
For example, the price of a
Sony 60" TV increases so
the demand for LG 60" TV
increases

Changes in the Changes in the price of Price of D for Price of D for

prices of complementary goods will Good A Good B Good A Good B
complementary influence the demand for a Increases Shifts Decreases Shifts
goods product/service Left Right
(D→D2) (D→D1)
There is an inverse
relationship between the
price of good A and
demand for good B
For example, the price of
printer ink increases so the
demand for ink printers
decreases

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Changes in If the population size of a Population D Shifts Population D

population country changes over time, Increases Right Decreases Shifts
Your notes
size/distribution then the demand for (D→D1) Left
goods/services will also (D→D2)
change
There is a direct
relationship between the
changes in population size
and demand
Demand will also change if
there is a change to the age
distribution in a country as
different ages demand
different goods/services
e.g an ageing population
will buy more hearing aids

Examiner Tips and Tricks

The difference between a movement along the demand curve and a shift in demand is essential to
understand. You will be repeatedly examined on this and it is important that you use the correct
language to show that you understand the difference between a change in quantity demanded and
a change in demand.
When price changes (ceteris paribus), there is a movement along the demand curve resulting in a
change to quantity demanded, which is a contraction or extension. When a condition of demand
changes, there is a shift of the entire demand curve, resulting in a change to demand, which is an
increase/rise or a decrease/fall.

Diminishing Marginal Utility

Marginal utility is the extra utility (satisfaction) gained from the consumption of an additional unit of a
product
The utility gained from consuming the first unit is usually higher than the utility gained from consuming
the next unit
For example, a hungry consumer gains high utility from eating their first hamburger. They are still
hungry and purchase a second hamburger but gain less satisfaction from eating it than they did
from the first hamburger

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To calculate total utility, the marginal utility of each unit consumed is added together
This means that total utility keeps increasing even while marginal utility is decreasing Your notes
The Law of Diminishing Marginal Utility states that as additional products are consumed, the utility
gained from the next unit is lower than the utility gained from the previous unit
The Law of Diminishing Marginal Utility helps to explain the reason why the demand curve is
downward sloping
When the first unit is purchased, the utility is high and consumers are willing to pay a higher price
When subsequent units are purchased, each one offers less utility and the willingness of the
consumer to pay the initial price decreases
Lowering the price makes it a more attractive proposition for the consumer to keep consuming
additional units
This is one reason why firms offer discounts such as '50% off the second item.'

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Price, Income & Cross Elasticities of Demand

Your notes
Price Elasticity of Demand (PED)
The law of demand states that when there is an increase in price, there will be a fall in quantity
demanded
Economists are interested by how much the quantity demanded will fall
Price elasticity of demand reveals how responsive the change in quantity demanded is to a change in
price
The responsiveness is different for different types of products

Calculation of PED
PED can be calculated using the following formula:

% change in quantity demanded % △ in QD

PED = =
% change in price % △in P

To calculate a % change, use the following formula:

new value − old value

% Change = × 100
old value

Worked Example
A firm raises the price of its products from £10 to £15. Its sales fall from 100 to 40 units per day.
Calculate the PED of its products
Step 1: Calculate the % change in QD

40 − 100
% △QD = × 100
100

% △QD = − 60 %

Step 2: Calculate the % change in P

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15 − 10
%△P = x 100
10
Your notes
% △ P = 50 %

Step 3: Insert the above values in the PED formula

% △ in QD
PED =
% △in P

− 60
PED =
50

PED = − 1. 2

The PED value will always be negative, so the answer must clearly state this. However, to explain the
degree of elasticity, ignore the minus sign to apply the values below

Interpreting PED values

The Size of PED Varies From 0 to Infinity (∞) and Is Classified As Follows

Value Name Explanation

0 Perfectly The QD is completely unresponsive to a

Inelastic change in P (very theoretical value e.g. heart transplant is extremely inelastic
but possibly not perfectly)

0→1 Relatively The %∆ in QD is less than proportional

Inelastic to the %∆ in P (e.g. addictive products)

1 Unitary The %∆ in QD is exactly equal to the %∆ in P

Elasticity

1→ ∞ Relatively The %∆ in QD is more than proportional

Elastic to the %∆ in P (e.g. luxury products)

∞ Perfectly The %∆ in QD will fall to zero with any

Elastic %∆ in P (highly theoretical elasticity)

Factors that influence the PED

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Some products are more responsive to changes in prices than other products
The factors that determine the responsiveness are called the determinants of PED and include: Your notes
1. Availability of substitutes: high availability of substitutes results in a higher value of PED (relatively
price elastic)
2. Addictiveness of the product: addictiveness turns products into necessities and habitual
consumption, resulting in a low value of PED (relatively price inelastic)
3. Price of product as a proportion of income: the lower the proportion of income the price represents,
the lower the PED value will be. Consumers are less responsive to price changes on cheaper products
(relatively price inelastic)
4. Time period: In the short term, consumers are less responsive to price increases, resulting in a low
value of PED (relatively price inelastic). Over a longer time period, consumers may feel the price
increase more and so look for substitutes, resulting in a higher value of PED (relatively price elastic)

Income Elasticity of Demand (YED)

Changes in income result in changes to the demand for goods/services
Economists are interested in how much the quantity demanded will change for different
products
Income elasticity of demand (YED) reveals how responsive the change in quantity demanded is to a
change in income

Calculation of YED
YED can be calculated using the following formula:

% change in quantity dem anded % △ in QD

YED = =
% change in incom e % △ in Y

Worked Example
A consumer's income rises from £100 to £125 a week. They originally consumed 12 bagels at the
local bakery but this increased to 15 bagels a week. Calculate the YED of the bagels
Step 1: Calculate the % change in QD

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15 − 12
% △QD = × 100
12
Your notes
% △QD = + 25 %

Step 2: Calculate the % change in Y

125 − 100
% △Y = x 100
100

% △Y = + 25 %

Step 3: Insert the above values in the YED formula

% △ in QD
PED =
% △in Y

25
Y ED =
25

Y ED = + 1

Even when the YED value is positive, the answer must clearly state this.

Interpreting YED Values

The YED value can be positive or negative and the value is important in determining the type of good
The Value of YED Determines the Type of Good and Response to Changes in Income

Value Type of Explanation

Good

0→1 Normal Demand increases proportionately less when income increases. Income
necessity inelastic, which means that demand is relatively less responsive to a change in
income

YED > Normal Demand increases proportionately more when income increases. Income
1 luxury elastic, which means demand is relatively more responsive to a change in
income

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YED < Inferior Demand decreases when income increases or vice versa so YED is negative
0 Good
Your notes

Factors that influence YED

YED is influenced by any factors in an economy which change the wages or salaries of workers
During a recession, incomes usually fall so the demand for inferior goods rises and the demand for
normal goods fall
During a period of economic growth and rising incomes, demand for normal goods rises and the
demand for inferior goods fall
Other influences on income include minimum wage legislation, taxation, and increased
international trade
The sign + or - shows the relationship: Normal good or inferior good
The number shows the strength of the relationship. For example, YED = +2.5 means there is a strong
relationship between a change in income and demand

Cross Price Elasticity of Demand (XED)

Changes in the prices of complementary goods and substitutes affect the demand for related
products
Cross price elasticity of demand (XED) reveals how responsive the change in quantity demanded for
good A is to a change in price of good B
The responsiveness is different for different types of products

Calculation of XED
XED can be calculated using the following formula:

% change in quantity dem anded of good A % △ in QDA

XED = =
% change in pric e of good B % △ in P B

Worked Example
Leading into the release of FIFA 22 Ultimate, EA Sports discounted the price of FIFA 21 from £90 to
£60. A game store in Winchester saw an increase in sales of their PlayStation 5 consoles. Prior to the

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discount they were selling 50 units a week and after the discount this increased to 80 units.
Calculate the XED and explain the relationship between the two products
Your notes
Step 1: Calculate the % change in QDA

80 − 50
% △QDA = × 100
50

% △ QDA = + 60 %

Step 2: Calculate the % change in PB

60 − 90
%△PB = x 100
90

% △ P B = − 33 . 33 %

Step 3: Insert the above values in the XED formula

% △ in QDA
X ED =
% △in P B

+60 %
X ED =
−33 . 33 %

X ED = − 1. 8

Step 4: Explain the relationship between the two products

The negative sign indicates that these two products are complements and the high value, which is
greater than 1 (ignoring the minus sign), suggests that they are strong complements

Interpreting XED Values

Using XED Values To Identify if Goods Are Complements, Substitutes, or Unrelated

Value Name Explanation

XED < Complementary The negative value indicates the two goods are complements.
0 goods The higher the value, the stronger the relationship

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XED > Substitutes The positive value indicates the two goods are substitutes.
0 The higher the value, the stronger the relationship
Your notes
XED = Unrelated goods A value of zero indicates that there is no relationship between the two
0 goods. The closer to zero, the weaker the relationship is

Significance of Elasticities to Firms & Governments

Knowledge of PED is important to firms seeking to maximise their revenue
If their product is price inelastic in demand, they should raise their prices
If price elastic in demand, then they should lower their prices
Knowledge of PED is important to Governments with regard to taxation and subsidies
If they tax price inelastic in demand products, they can raise tax revenue without harming firms
too much
Consumers are less responsive to price changes so firms will pass on the tax to the consumer
If they subsidies price elastic in demand products, there can be a greater than proportional
increase in demand
Knowledge of XED is important to firms as they seek to maximise their revenue
It can help them adjust pricing strategies for substitute and complementary products
It can help them understand the likely impact of competitors' pricing strategies on their sales
Knowledge of YED is important to firms as they seek to maintain sales and maximise profits through
periods of recession or economic growth
Firms should consider providing more inferior goods in a recessionary environment
Firms should consider providing more income elastic normal goods/ luxury products during
periods of economic growth

The Revenue Rule of PED

The total revenue rule states that in order to maximise revenue, firms should increase the price of
products that are price inelastic in demand and decrease prices on products that are price elastic in
demand

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Worked Example
A firm raises the price of its products from £10 to £15. Its sales have fallen from 100 to 40 units per Your notes
day. Explain if it made the correct decision
Step 1: Calculate the initial sales revenue

Sales Revenue = Price of product X Quantity sold

= £ 10 x 100
= £ 1,000

Step 2: Calculate the sales revenue after the price change

Sales Revenue = Price of product X Quantity sold

= £ 15 x 40
= £ 600

Step 3: Explain the decision

By raising the price, the total revenue has fallen by £400. This indicates that the product is price
elastic in demand and the firm should have lowered their price in order to increase revenue

Examiner Tips and Tricks

A common error students make is to say that when prices increase and the product is price inelastic
in demand, the quantity demanded does not fall. It does! But it is a less than proportionate fall than
the increase in price
Remember that the demand curve is downward sloping and the PED is measuring the extent to
which the quantity demanded moves along the demand curve when price changes. Even though
water is essential, households would find ways to contract their consumption if the supply of water
to their homes became more expensive
When governments tax demerit goods such as cigarettes, the increase in price is greater than the
decrease in QD, but QD still falls
The values of YED and XED determine the size of the shift in the demand curve. For example, if XED
= -0.2, the demand for product A will fall by a relatively smaller percentage than the rise in price of
product B. The shift in the demand curve to the left will be small

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Supply
Your notes
Supply
Supply is the amount of a good/service that a producer is willing and able to supply at a given price
in a given time period
A supply curve is a graphical representation of the price and quantity supplied by producers
If data were plotted, it would be an actual curve, however economists simplify curves in their
sketches into straight lines so as to make analysis easier
The supply curve is sloping upward as there is a positive relationship between price and quantity
supplied
Rational profit maximising producers would want to supply more as prices increase in order to
maximise their profits

A supply curve showing an extension in quantity supplied (QS) as prices increase and a contraction in
quantity supplied (QS) as prices decrease

Diagram analysis
If price is the only factor that changes (ceteris paribus), there will be a change in the quantity supplied
(QS)
This change is shown by a movement along the supply curve

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An increase in price from £7 to £9 leads to a movement up the supply curve from point A to B
Due to the increase in price, the quantity supplied has increased from 10 to 14 units Your notes
This movement is called an extension in QS
A decrease in price from £7 to £4 leads to a movement down the supply curve from point A to C
Due to the decrease in price, the quantity supplied has decreased from 10 to 7 units
This movement is called a contraction in QS
The Conditions of Supply
There are several factors that will change the supply of a good/service, irrespective of the price level.
Collectively these factors are called the conditions of supply
Changes to any of the conditions of supply shifts the entire supply curve (as opposed to a movement
along the supply curve)

A graph that shows how changes to any of the conditions of supply shifts the entire supply curve left or
right, irrespective of the price level

For example, if a firm's cost of production increases due to the increase in price of a key resource, then
there will be a decrease in supply as the firm can now only afford to produce fewer products
This is a shift in supply from S to S1. The price remains unchanged at £7 but the supply has
decreased from 10 to 2 units
An Explanation of How Each of the Conditions of Supply Shifts the Entire Supply Curve at Every Price
Level

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Condition Explanation Condition Shift Condition Shift

Your notes
Costs of If the price of raw materials or COP S Shifts COP S Shifts
Production other Increases Left Decreases Right
(COP) costs of production change, (S→S1) (S→S2)
firms respond by changing
supply

Indirect Taxes Any changes to specific taxes or Taxes S Shifts Taxes S Shifts
ad valorem taxes change the Increase Left Decrease Right
cost of production for a firm and (S→S1) (S→S2)
impact supply

Subsidies Changes to producer subsidies Subsidy S Shifts Subsidy S Shifts

directly impact the cost of Increases Right Decreases Left
production for the firm (S→S2) (S→S1)

New New technology increases Technology S Shifts Technology S Shifts

Technology productivity and lowers costs Increases Right Decreases Left
of production. Ageing (S→S2) (S→S1)
technology can have the
opposite effect

Change in the The entry and exit of firms into No. of Firms S Shifts No. of Firms S Shifts
number of the market has a direct impact Increases Right Decreases Left
firms in the on the supply. If ten new firms (S→S2) (S→S1)
industry start selling building materials in
Nuneaton, the supply of building
material will increase

Examiner Tips and Tricks

Several of the conditions of supply change the costs of production. However, be sure to explain
each condition as its own point before linking it to the cost of production (for example, a change in
indirect taxation)

A common error by students is to explain that a subsidy (for example, £3,000 subsidy for each
electric vehicle produced) shifts the demand curve for electric vehicles to the right. This is incorrect.

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The subsidy will shift the supply curve to the right. Then, due to the lower price, there will be a
movement along the demand curve (extension of quantity demanded) to create a new market
equilibrium Your notes

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Elasticity of Supply
Your notes
Price Elasticity of Supply (PES)
The law of supply states that when there is an increase in price (ceteris paribus), producers will
increase the quantity supplied and vice versa
Economists are interested by how much the quantity supplied will increase
Price elasticity of supply (PES) reveals how responsive the change in quantity supplied is to a change
in price
The responsiveness is different for different types of products

Calculation of PES
PES can be calculated using the following formula

% change in quantity supplied % △ in QS

PES = =
% change in price % △in P

To calculate a % change, use the following formula

new value − old value

% Change = × 100
old value

Worked Example
In recent months, the price of avocados has increased from £0.90 to £1.45. Bewdley Farm Shop in
the Severn valley have sought to maximise their profits by increasing the quantity supplied to
market. They have been able to increase sales from 110 units a week to 120 units a week. Calculate
the PES of avocados and explain one reason for the value
Step 1: Calculate the % change in QS

120 − 110
% △ QS = × 100
110

% △ QS = + 9. 1 %

Step 2: Calculate the % change in P

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1. 45 − 0. 90
%△P = x 100
0. 90
Your notes
% △ P = + 61 %

Step 3: Insert the above values in the PES formula

% △ in QS
PE S =
% △in P

9. 1 %
PE S =
61 %

PE S = + 0. 15

Step 4: Explain one reason for the value

The PES value of + 0.15 indicates that avocados are very price inelastic in supply. Even with a
significant increase in price, suppliers are less able to supply more due to the time it takes to grow
additional avocados

Examiner Tips and Tricks

All PES values are positive, reflecting the relationship between price and quantity on the supply
curve. It is a measure of the extent to which the quantity supplied moves along the supply curve after
a price change
When undertaking any elasticity calculations, make sure that your final answer is not expressed as a
percentage. This is a common error and loses marks

Interpreting PES values

The Values of PES Vary From 0 to Infinity (∞) and They Are Classified As Follows

Value Name Explanation

0 Perfectly The QS is completely unresponsive to a

Price Inelastic change in P (e.g. fixed number of seats in a theatre) so the supply curve is
vertical

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0→1 Relatively The %∆ in QS is less than proportional

Price Inelastic to the %∆ in P (e.g agricultural products)
Your notes
1→ ∞ Relatively The %∆ in QS is more than proportional
Price Elastic to the %∆ in P (e.g t-shirts)

∞ Perfectly The %∆ in QS will fall to zero with any %∆ in P. However, supply is unlimited at a
Price Elastic particular price. This is a very theoretical scenario but is evident when
examining international trade diagrams. The supply curve is horizontal

Factors that influence the PES

Some products are more responsive to changes in prices than other products
The factors that determine the responsiveness are called the determinants of PES and include:
1. Mobility of the factors of production: if producers can quickly switch their resources between
products, then the PES will be more price elastic. For example, if prices of hiking boots increase and
shoe manufacturers can switch resources from producing trainers to boots, then boots will be price
elastic in supply
2. Availability of raw materials: if raw materials are scarce, then PES will be low (price inelastic). If they
are abundant, PES will be higher (price elastic)
3. Ability to store goods: if products can be easily stored, then PES will be higher (price elastic) as
producers can quickly increase supply (for example, tinned food products). An inability to store
products results in lower PES (price inelastic)
4. Spare capacity: if prices increase for a product and there is capacity to produce more in the factories
that make those products, then supply will be price elastic. If there is no spare capacity to increase
production, then supply will be price inelastic
5. Time period: In the short run, producers may find it harder to respond to an increase in prices as it
takes time to produce the product (e.g avocados). However, in the long run, producers can change
any of their factors of production so can produce more

Examiner Tips and Tricks

Many students confuse PES with PED and inadvertently answer questions using knowledge from
PED. When faced with PES questions, make yourself think like a producer (and not a consumer!) and
it will help you stay focused on providing the correct answer.

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Distinction Between Short-run & Long-run

The resources used in production are called factors of production Your notes

All four factors of production are required to produce any good/service

Land: non man-made resources used in production (e.g. coal)
Capital: man-made resources used in production (e.g. MRI machine or fertiliser)
Labour: workers involved in the production process
Entrepreneurship: the individual(s) involved in organising the other factors of production
Economists differentiate between the short-run and the long-run periods of production and these
definitions relate to the factors of production. It is not a physical period of time
Short-run is any period of time in which at least one factor of production is fixed and this is a
limiting factor. For example, Lego may be able to vary all factors of production in the short-run,
except for the number of factories (capital) that they have
Long-run is any period of time in which all the factors of production are variable (it is also called
the planning stage). Producers are able to vary all of their resources to respond to changing
market conditions. For example, Lego could build a new factory to take advantage of higher
prices or greater demand

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Price Determination
Your notes
Price Determination & Equilibrium
Price determination
In a free market economy, prices are determined by the interaction of demand and supply in a market
A market is any place that brings buyers and sellers together
Markets can be physical (e.g. Waterstones) or virtual (e.g. eBay)
Buyers and sellers meet to trade at an agreed price
Buyers agree the price by purchasing the good/service
If they do not agree on the price then they do not purchase the good/service and are exercising
their consumer sovereignty
Based on this interaction with buyers, sellers will gradually adjust their prices until there is an
equilibrium price and quantity that works for both parties
At the equilibrium price, sellers will be satisfied with the rate/quantity of sales
At the equilibrium price, the utility/price combination is maximised for the buyers

Equilibrium
Equilibrium in a market occurs when demand = supply
At this point the price is called the market clearing price
This is the price at which sellers are clearing their stock at an acceptable rate

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Your notes

A graph showing a market in equilibrium with a market clearing price at P and quantity at Q

Any price above or below P creates disequilibrium in this market

Disequilibrium occurs whenever there is excess demand or supply in a market

Market Disequilibrium
Disequilibrium - excess demand
Excess demand occurs when the demand is greater than the supply
It can occur when prices are too low or when demand is so high that supply cannot keep up with it

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Your notes

A graph that depicts the condition of excess demand in the market for electric scooters

Diagram analysis
At a price of P1, the quantity demanded of electric scooters (Qd) is greater than the quantity supplied
(Qs)
There is a shortage in the market equivalent to QsQd

Market response
This market is in disequilibrium
Sellers are frustrated that products are selling so quickly at a price that is obviously too low
Some buyers are frustrated as they will not be able to purchase the product
Sellers realise they can increase prices and generate more revenue and profits
Sellers gradually raise prices
This causes a contraction in QD as some buyers no longer desire the good/service at a higher
price
This causes an extension in QS as sellers are more incentivised to supply at higher prices
In time, the market will have cleared the excess demand and arrive at a position of equilibrium (PeQe)

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Different markets take different lengths of time to resolve disequilibrium. For example, retail
clothing can do so in a few days. Whereas the housing market may take several months
Your notes
Disequilibrium - excess supply
Excess supply occurs when the supply is greater than the demand
It can occur when prices are too high or when demand falls unexpectedly
During the later stages of the pandemic the market for face masks was in disequilibrium

A graph that depicts the condition of excess supply in the market for Covid-19 face masks during the
later stages of the pandemic

Diagram analysis
At a price of P1, the quantity supplied of face masks (Qs) is greater than the quantity demanded (Qd)
There is a surplus in the market equivalent to QdQs

Market response
This market is in disequilibrium
Sellers are frustrated that the masks are not selling and that the price is obviously too high
Some buyers are frustrated as they want to purchase the masks but are not willing to pay the high
price
Sellers will gradually lower prices in order to generate more revenue

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This causes a contraction in QS as some sellers no longer desire to supply masks

This causes an extension in QD as buyers are more willing to purchase masks at lower prices Your notes
In time, the market will have cleared the excess supply and arrive at a position of equilibrium (PeQe)
Use of Diagrams to Show Market Changes
Real world markets are constantly changing and are referred to as dynamic markets
Market equilibrium can change every few minutes in some markets (e.g. stocks and shares), or every
few weeks or months in others (e.g. clothing)
Any change to a condition of demand or supply will temporarily create disequilibrium and market
forces will then seek to clear the excess demand or supply

Real world example: changes to demand that increase price

During lock downs associated with the Covid-19 pandemic, furniture retailers experienced
unexpectedly high demand for their products (especially desks and sofas)

Diagram showing an increase in demand for desks due to a temporary change in tastes/fashions

Diagram analysis
Due to the Covid mandated change of working from home, consumers experienced a temporary
change in taste as they sought to set up comfortable home offices
This led to an increase in demand for desks from D1→D2

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At the original market clearing price of P1, a condition of excess demand now exists
The demand for desks is greater than the supply Your notes
In response, suppliers raise prices
This causes a contraction of demand and an extension of supply, leading to a new market
equilibrium at P2Q2
Both the equilibrium price (P2) and the equilibrium quantity (Q2) are higher than before
The excess demand in the market has been cleared
Real world example: changes to supply that increase price
Ukraine is one of the world's largest producers of wheat. During the Russian-Ukrainian war, exports of
wheat have been halted
India imported 13% of the nation's wheat requirements from Ukraine

Diagram showing an decrease in supply of wheat in India due to a supply shock caused by the war in
Ukraine

Diagram analysis
Due to the war in Ukraine, India is experiencing a supply shock in its wheat market
This causes a decrease in supply of S1→S2
At the original market clearing price of P1, a condition of excess demand now exists (shortage)

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The demand for wheat is greater than the supply

In response, sellers in India raise prices
Your notes
This causes a contraction of demand and an extension of supply, leading to a new market
equilibrium at P2Q2
The equilibrium price (P2) is higher and the equilibrium quantity (Q2) is lower than before
The excess demand in the market has been cleared
Real world example: changes to demand that decrease price
Demand for lobsters in Maine, USA has been falling steadily in recent months
This has resulted in a price fall from $12.35 /pound on the 1st April to $9.35 /pound on the 1st May

Diagram showing a decrease in demand for lobsters due to a decrease in real income

Diagram analysis
In recent months, the USA has been experiencing an increasing rate of inflation
Inflation lowers the purchasing power of money in a consumer's pocket and so effectively
reduces their real income
With reduced real income, fewer luxuries are consumed
This led to a decrease in demand for lobsters from D1→D2
At the original market clearing price of P1, a condition of excess supply now exists

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The demand for lobsters is less than the supply

In response, suppliers gradually reduce prices
Your notes
This causes a contraction of supply and an extension of demand leading to a new market
equilibrium in P2Q2
Both the equilibrium price (P2) and the equilibrium quantity (Q2) are lower than before
The excess supply in the market has been cleared
Real world example: changes to supply that decrease price
In order to help meet their climate targets and to lower energy costs for households, the EU is
providing subsidies for solar panels

Diagram showing an increase in supply of solar panels in the EU due to a per unit subsidy

Diagram analysis
To help meet its climate change targets and lower household energy bills the EU has provided
subsidies to solar panel retailers
This causes an increase in supply of S1→S2
At the original market clearing price of P1, a condition of excess supply now exists (surplus)
The supply of solar panels is greater than the demand
In response, sellers in the EU lower prices

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This causes an extension of demand and a contraction of supply, leading to a new market
equilibrium at P2Q2
Your notes
The equilibrium price (P2) is lower and the equilibrium quantity (Q2) is higher than before
The excess supply in the market has been cleared

Examiner Tips and Tricks

MCQ, short answer and essay questions frequently require you to explain dynamic changes in
markets. Explaining the steps in the change is often referred to as chains of analysis or reasoning,
and students frequently leave out some steps in the chain.
Step 1: From the scenario, identify if the change in condition is on the demand side or supply side.
Step2: State which way the demand or supply curve moves and use annotation, e.g. S1→S2.
Step 3: State the disequilibrium that now exists at the original market price.
Step 4: State if sellers raise or lower prices to clear the disequilibrium.
Step 5: Explain the relevant contraction and extension in quantity that occurs on the demand and
supply curves due to the change in price.
Step 6: State the new market equilibrium points e.g. P2Q2.
Step 7: Explain the market outcome (is the new price/quantity higher/lower than the original?)

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Price Mechanism
Your notes
Functions of The Price Mechanism
The price mechanism is the interaction of demand and supply in a free market
This interaction determines prices which are the means by which scarce resources are allocated
between competing wants/needs
The price mechanism fulfils three functions in the relationship between buyers and sellers
Rationing: prices allocate (ration) scarce resources. When resources become scarcer the price
will rise further. Only those who can afford to pay for them will receive them. If there is a surplus
then prices fall and more consumers can afford them
Signalling: prices provide information to producers and consumers where resources are required
(in markets where prices increase) and where they are not (in markets where prices fall)
Incentive: when prices for a good/service rise, it incentivises producers to reallocate resources
from a less profitable market to this market in order to maximise their profits. Falling prices
incentivise reallocation of resources to new markets
Adam Smith referred to the functions of the price mechanism as the 'mystery of the invisible hand'

Price Mechanism at Work in Different Markets

The price mechanism operates in all markets including local, national and global

Price mechanism in a local market

Long Island, USA has a rich history of agriculture and many producers set up farm shops selling directly
to the public. In recent years, honey consumption has increased

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Your notes

A diagram showing the increase in demand for honey in a local market, Long Island

Due to a change in one of the conditions of demand (most likely change in tastes), the demand for
honey in the local market has increased from D1→D2 and the price has increased from $15 to $18
The higher price serves to ration a valuable product. Those consumers who can afford to purchase
it at $18, receive it
The higher price incentivises producers to allocate more factors of production to producing
honey and this is evident from the extension in supply from Q1 to Q2
The shift in demand signals to other producers that demand for honey is strong and they should
consider entering the market

Examiner Tips and Tricks

It can get confusing explaining some of the differences between the three functions. Thinking about
it in the following way helps to simplify the process. If there is shift in demand/supply the market is
sending a signal to consumers and producers. If there is a movement along one of the curves, this is
as a result of the incentive function.

Price mechanism in a national market

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The T-Shirt market in the UK is highly competitive. In 2018 the price of cotton fell

Your notes

A diagram showing an increase in the supply of T-shirts in the UK market

Price mechanism in a global market

Cash crops such as wheat, oats, barley, soy, corn, sunflowers etc. can be grown using the same factors
of production
Many countries export excess crops into the world market
Producers use world prices to guide their production decisions

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Your notes

A diagram showing the price mechanism at work in two related global markets, corn and potatoes

Farmers in France have been producing corn for many years and the market price is $2/kg. The price of
potatoes in global markets has until recently been steady at $2/kg
Due to a change in one of the conditions of demand (possibly an increase in global population), the
demand for potatoes has increased from D1→D2 and the price has increased from $2/kg to $3/kg
The higher price serves to ration the potatoes. Those consumers who can afford to purchase it for
$3, receive it
The higher price incentivises producers to allocate more factors of production to producing
potatoes and this is evident from the extension in supply from Q1 to Q2
The shift in global demand signals to producers in France that demand for potatoes is strong and
they should consider switching some of their production from corn to potatoes

Examiner Tips and Tricks

Whenever you are faced with questions on the functions of the price mechanism, remember that all
three functions are built on the principle of self-interest. This will help you to explain each function.
For example, lower prices incentivise consumers to purchase more of the product with the same
income. Conversely, the incentive for producers is the opposite, encouraging them to reallocate
their factors of production to producing more profitable products.
Each party acts in their self interest

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Producer & Consumer Surplus

Your notes
Producer & Consumer Surplus
Consumer surplus is the difference between the amount the consumer is willing to pay for a product
and the price they have actually paid
For example, if a consumer is willing to pay £18 to watch a movie and the price is £15, their
consumer surplus is £3
Producer surplus is the difference between the amount that the producer is willing to sell a product
for and the price they actually receive
For example, if a producer is willing to sell a laptop for £450 and the price is £595, their producer
surplus is £145

A market diagram illustrating consumer and producer surplus

Diagram analysis
The area between the horizontal equilibrium price line and the demand curve represents the
consumer surplus in the market (ABPe)
The consumer surplus lies underneath the demand curve

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The area between the horizontal equilibrium price line and the supply curve represents the producer
surplus in the market (CBPe)
Your notes
Producer surplus lies above the supply curve
When the market is at equilibrium the producer and consumer surplus are maximised
Consumer surplus + producer surplus = social/community surplus
Any disequilibrium reduces the social surplus
How Market Changes Affect Producer & Consumer
Surplus
Any change to the condition of supply or demand will cause a shift in the relevant curve
This shift will change the consumer and producer surplus in the market

An increase in supply

The condition of supply has changed and the diagram on the left shows the resulting change to
consumer surplus while the diagram on the right shows the change to producer surplus

Diagram analysis
Prior to the change in the condition of supply
Consumer surplus was equivalent to ACE and producer surplus was equivalent to ACF
Social surplus was equivalent to ECF
After the change, supply increased S1→S2

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Consumer surplus was equivalent to BED and producer surplus was equivalent to BDG
Social surplus was equivalent to DEG Your notes
Both the consumer surplus and producer surplus have increased as a result of the increased supply in
the market
An increase in demand

The condition of demand has changed and the diagram on the left shows the resulting change to
producer surplus while the diagram on the right shows the change to consumer surplus

Diagram analysis
Prior to the change in the condition of demand
Producer surplus was equivalent to ACE and consumer surplus was equivalent to ACF
Social surplus was equivalent to ECF
After the change, demand increased D1→D2
Producer surplus was equivalent to BED and consumer surplus was equivalent to BDG
Social surplus was equivalent to DEG
Both the producer surplus and consumer surplus have increased as a result of the increased demand
in the market

Examiner Tips and Tricks

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MCQ frequently tests your ability to identify changes to consumer and producer surplus. In essay
responses, even if it is not explicitly mentioned, you can refer to these concepts when evaluating
dynamic markets and the impacts on different stakeholders. It demonstrates excellent economic Your notes
knowledge and analysis.
Changes to consumer and producer surplus become slightly more complicated when analysing the
impact of government intervention such as indirect taxes, subsidies and price controls.

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Indirect Taxes & Subsidies

Your notes
Indirect Taxes
An indirect tax is paid on the consumption of goods/services
It is only paid if consumers make a purchase
It is usually levied by the government on demerit goods to reduce the quantity demanded (QD)
and/or to raise government revenue
Government revenue is used to fund government provision of goods/services e.g education
Indirect taxes can occur as a specific or ad valorem tax
They are levied by the government on producers. This is why the supply curve shifts
Producers and consumers each pay a share (incidence) of the tax

The incidence of a specific tax

A diagram that demonstrates the share of a specific tax paid by the consumer (A) and the producer (B)

Diagram analysis
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The government places a specific tax on a demerit good

The supply curve shifts left from S1→S2 by the amount of the tax Your notes
The price the consumer pays has increased from P1 before the tax, to P2 after the tax
The price the producer receives has decreased from P1 before the tax to P3 after the tax
The government receives tax revenue = (P2-P3) x Q2
The consumer incidence (share) of the tax is equal to area A - (P2-P1) x Q2
The producer incidence (share) of the tax is equal to area B - (P1-P3) x Q2
The QD in this market has decreased from Q1→Q2
If the decrease in QD is significant enough, it may force producers to lay off some workers

Examiner Tips and Tricks

When drawing this diagram, students often find it hard to identify the three price points.
The tax incidence boxes are formed by drawing the new equilibrium quantity through the original
supply curve. The three price points are the old equilibrium point, new equilibrium point - and
where the new quantity crosses the original supply curve.
Irrespective if you are dealing with taxes or subsidies, always use the new equilibrium point to
determine your incidence boxes.
The consumer incidence is paid from the consumer surplus area and the producer incidence is paid
from the producer surplus area.

A side by side comparison of the impact of PED on tax incidence

Aiming to maximise their profits, producers pass on as much of the indirect tax as they can to
consumers and pay the balance themselves
The amount passed on to consumers depends on the price elasticity of demand (PED) of the
product

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Your notes

A diagram that demonstrates the tax incidence for a product whose PED is inelastic (left) and elastic
(right). A is the consumer incidence and B is the producer incidence

Diagram analysis
In both diagrams, the specific tax shifts the supply curve from S1→S2
There is a higher market price at P2 and lower QD at Q2
Tax revenue for the government is the sum of A+B
Consumer incidence is represented by A and producer incidence by B
Total revenue for the seller is calculated using P3 X Q2
The difference in PED results in a different steepness to the demand curve
For a price inelastic product (e.g. cigarettes), producers pass on a much higher proportion of the
tax to consumers (A) and pay the rest themselves (B)
The QD decreases (Q1→Q2) but by a much smaller proportion than the increase in price
(P1→P2)
For a price elastic product (e.g. pizza), producers pass on a much smaller proportion of the tax to
consumers (A) and pay the rest themselves (B)
The QD decreases (Q1→Q2) but by a much larger proportion than the increase in price (P1→P2)

Examiner Tips and Tricks

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When asked to evaluate the impact of a tax in a particular market, it is essential to apply knowledge
of PED to the impact it will have on producers, consumers and the government.
Your notes
It should be obvious from the context if the product in the question is price elastic or inelastic in
demand. If not, work through the factors that determine PED and make a judgement as to whether
the product is price elastic or inelastic in demand. In your answer, explain your reasoning.

Subsidies
A producer subsidy is a per unit amount of money given to a firm by the government
To increase production
To increase provision of a merit good
The incidence (share) of the subsidy is determined by the PED of the product
If governments subsidise goods/services with high PED, the increase in QD will be more than
proportional to the decrease in price
Producers keep some of the subsidy and pass the rest on to the consumers

A diagram which demonstrates the cost of a subsidy to the government (A+B) and the incidence
received by the consumer (A) and producer (B)

Diagram analysis
The original equilibrium is at P1Q1

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The subsidy shifts the supply curve from S → S + subsidy:

This increases the QD in the market from Q1→Q2 Your notes
The new market equilibrium is P2Q2
This is a lower price and higher QD in the market
Producers receive P2 from the consumer PLUS the subsidy per unit from the government
Producer revenue is therefore P3 x Q2
Producer incidence of the subsidy is marked B in the diagram
The subsidy decreases the price that consumers pay from P1 → P2
Consumer incidence of the subsidy is marked A in the diagram
The total cost to the government of the subsidy is (P3 - P2) x Q2 represented by area A+B

Examiner Tips and Tricks

Memorise the distinction below as students get very confused when answering questions on
subsidies.
When dealing with a subsidy, the producer benefit is now the top portion of the incidence area
and consumer incidence is below. This can be confusing as in all other diagrams, it is the other way
around (surplus, indirect tax etc.)
Logically, it makes sense. Producers are given an extra amount of money for each unit by the
government so this raises the sales revenue they receive, while at the same time lowering the price
consumers pay.

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Alternative Views of Consumer Behaviour

Your notes
Alternative Views of Consumer Behaviour
Free markets are built on the assumptions of rational decision making
In classical economic theory, the word 'rational' means that economic agents are able to consider the
outcome of their choices and recognise the net benefits of each one
Rational agents will select the choice which presents the highest benefits
In many ways, the assumption of rational decision making is flawed. Consumers are often more
influenced by the following than a rational computation of net benefits
The influence of other people's behaviour
The importance of habitual behaviour
Consumer weakness in computation

The influence of other people's behaviour

Peer pressure often prompts consumers to make purchasing decisions that may go against a
computation of net benefits. Consumers tend to exhibit herding behaviour
Producers influence consumers' choices through various forms of promotion, such as advertising,
celebrity endorsements and influencer culture
This results in emotional decisions and not necessarily rational decisions e.g. consumers
purchasing the branded Nurofen when they could purchase the much cheaper (and essentially
identical) Ibuprofen
Producers use advanced behavioural psychology techniques to influence consumer choices e.g.
Neuro branding

The importance of habitual behaviour

Consumers make so many purchasing decisions so they often rely on habits to speed up the process
Using rule of thumb refers to a short cut that makes a quick estimation of benefits without
gathering too much information
Consumers use information from the past, which may be outdated, as they habitually purchase
the same products, e.g. visiting the same sections in a supermarket for several years
Consumer inertia often develops as convenience is prioritised

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Consumers make purchasing decisions that directly harm them and are usually addictive, for e.g.
alcohol
Your notes
Sellers recognise habitual patterns and exploit them. For example, products placed at the checkout
till to benefit from impulse purchasing (chewing gum)
Consumer weakness at computation
The wider the range of choice, the harder it is for a consumer to gather information and compute which
one offers the highest net benefits
Consumers often lack the time or ability to consider the relative prices of different products and
sellers will frequently make it difficult for them to do so
Products the seller wants to sell are often placed at eye level where computation is easy
Many products that would deliver higher benefits are placed below knee level or high on the shelf
where computation is harder

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