ECONOMICS
A-LEVEL edexcel (Multiple choice & Essays)
Basic economic problem - scarcity & choice
The purpose of economic activity
It is often said that the central purpose of economic activity is the production of goods
and services to satisfy our ever-changing needs and wants.
The basic economic problem is about scarcity and choice. Every society has to decide:
What goods and services to produce? Does the economy uses its resources to
build more hospitals, roads, schools or luxury hotels? Do we make more iPhones
and iPads or double-espressos? Does the National Health Service provide free
IVF treatment for childless couples?
How best to produce goods and services? What is the best use of our scarce
resources? Should school playing fields be sold off to provide more land for
affordable housing? Should we subsidise the purchase of solar panels for roofs?
Who is to receive goods and services? Who will get expensive hospital treatment and who not? Should there be a minimum wage? Or perhaps a living wage?
What are the causes and consequences of poverty in societies across the globe?
Scarcity
We are always uncovering of new wants and needs which producers attempt to supply
by using factors of production. For a perspective on the achievements of countries in
meeting peoples basic needs, theHuman Development Index produced by the United
Nations is worth reading. The economist Amartya Sen(Winner of the 1998 Nobel Prize
for Economics) has written extensively on this issue.
Scarcity means we all have to make choices
Because of scarcity, choices must be made by consumers, businesses and governments.
For example, over six million people travel into London each day and they make
decisions about when to travel, whether to use the bus, the tube, to walk or cycle or
work from home. Millions of decisions are taken, many of them are habitual but
somehow on most days, people get to work on time and they get home too in safety if not
in comfort!
Making a choice made normally involves a trade-off this means that choosing more of
one thing can only be achieved by giving up something else in exchange.
Every purchase is a trade-off, of course. If you decide to spend $20,000 on a new car,
youre saying thats worth more to you than 20 bicycles or four vacations to Europe or the
down payment on a house. Every choice involves opportunity costs; when you choose one
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thing, youre giving up others. Plus, what youre giving up isnt always [Link]
obvious.
1. Housing: Choices about whether to rent or buy a home both decisions
involve risk. People have to weigh up the costs and benefits of the decision.
2. Working: Do you work full-time or part-time? Is it worth your while studying
for a degree? How have these choices been affected by the introduction of
university tuition fees?
3. Transport and travel: The choice between using Euro-Tunnel, a low-cost ferry or
an airline when travelling to Western Europe.
In many decisions where people consider the costs and benefits of their actions
economists make use of the marginal idea, for example what are the benefits of
consuming a little extra of a product and what are the costs?
Rational decision-makers weigh the marginal benefit one receives from an option
with its marginal cost, including the opportunity cost.
This cost benefit principle well applied will get you a long way in economics!
But keep in mind that behavioural economics questions the rationality of many
of our decisions!
Housing
The determination of price levels in local housing markets are great examples of
microeconomics in action! Each day there are hundreds and thousands of separate
negotiations between buyers and sellers with prices being offered and agreed before a
final transaction is made.
The price that is established with each housing transaction in the market depends on
The price that the seller is willing to agree for their property.
The actual price that the buyer is willing and able to pay
A Sellers Market
When demand for properties in a locality, area or region is high and when there is a
shortage of properties then the balance of power in the market shifts towards the seller.
They can wait for offers on their property to reach (or exceed) their minimum selling
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price. Indeed early potential buyers may come straight in with an offer in excess of the
asking price in order to avoid the possibility of losing the property that they want.
A Buyers Market
When there is a glut of properties available on the market (excess supply), the balance
of power switches to buyers. They have the luxury of a wider choice of housing and they
should be able to negotiate a price lower than the published price. Sellers may require a
quick sale and this puts extra bargaining power into the hands of buyers.
Housing Demand
The demand for housing is the quantity of properties that homebuyers are willing and
able to buy at a given price in a given time period. Some of the conditions of demand in
the market are as follows:
Real Incomes: As living standards rise, so the demand for housing expands,
including demand for more expensive properties as people move up market.
Mortgage Interest Rates: Since most homes are purchased with a mortgage,
changes in interest rates affect demand for housing. A rise in mortgage rates
increases the cost of financing the loan on the purchase of a property.
Consumer confidence: Consumer confidence is vital for if expectations for the
future performance of the economy deteriorate and people become less
optimistic about their own financial circumstances, they may be tempted to delay
entry into the market for property.
Economic Growth: When the economy is enjoying sustained growth and rising
prosperity, improved confidence raises the number of homebuyers. The reverse
is true in a recession.
Unemployment: In areas or regions when unemployment is above the national
average, incomes will be lower and this limits the number of people who are able
to afford properties.
The Price of Substitutes: For people wanting to buy their own home, the main
alternative is to rent so a higher cost of renting could lead to an increased
demand for owner-occupied homes.
Effective demand for housing property affordability
Demand in a market is only effective when potential buyers have the ability to pay.
Nowhere is this truer than in the property market. In recent years the boom in house
prices in the UK caused a major affordability problem for millions of people wanting to
enter the market for the first time. The ratio of average prices to incomes climbed
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higher and made it much more expensive to take out a mortgage. The decline in
effective demand has been an important factor bringing about an end to the boom as
first-time-buyers have gradually disappeared from the market.
Since the summer of 2007 house prices have been falling and as a result, the ratio of
prices to earnings has dropped indicating an improvement in this measure of housing
affordability. However although properties look more affordable at first glance, the
difficulties in getting a mortgage following the credit crunch means that demand in the
property market has remained subdued.
Price elasticity of demand for housing
Price elasticity of demand (Ped) measures the responsiveness of demand for a product
to a change in its own price. When housing is regarded as a necessity and when there
are few close substitutes available, we expect demand to be inelastic. This may well force
up the eventual market price when a transaction is agreed.
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ECONOMICS
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The price elasticity of demand for a property depends on the availability of close
substitutes for example the supply of rented housing. If you have set your heart on a
particular property, or are convinced that you need to live in a specific area, perhaps to
live within a school catchment area or because you want to be close to friends and
family, then you will be far less sensitive to the market price and demand will become
price inelastic.
Housing Supply
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The housing supply is the total flow of properties available at a given price in a given
time period. The supply will be a mix of newly-built housing and older properties. For
new housing, the conditions of supply include the following:
1. Costs of production for construction companies
a. Employment costs (including wages, overtime payments and employment
taxes).
b. Costs of purchasing land for housing development.
c. Costs of purchasing building components and raw materials.
d. Costs associated with achieving planning consent from local authorities.
1. The number of construction companies in the market and their business
objectives.
2. The extent to which property builders can achieve economies of scale in house
building and reduce their constructions costs by implementing innovation in
building projects.
3. Government taxation and subsidy of new housing developments
Elasticity of Housing Supply
The supply of new housing tends to be inelastic in the short run which means that house
prices are determined almost exclusively by demand factors such as income,
unemployment and interest rates. Several reasons have been put forward for the low
price elasticity of supply of housing:
1. Construction companies cannot suddenly plan and then build thousands of new
homes in areas when there is an increase in demand. One reason is the existence
of planning regulations and other constraints on new housing developments.
2. Supply is also restricted by the limited availability of skilled labour such as
bricklayers and electricians and other factor inputs needed in the construction
process.
Explaining property price differences
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ECONOMICS
A-LEVEL edexcel (Multiple choice & Essays)
What supply and demand factors might help to explain persistent differentials in
property prices in different parts of the UK? Consider the evidence shown in the chart
above average prices in London have outstripped those for the UK as a whole for
many years not and the gap has widened:
Some the factors might include:
Population growth driving total market demand for housing higher every year
The absence of a ready supply of affordable rented housing and social housing
Higher per capita incomes among people living in London even though the
unemployment rate is higher than the national average (there are many
economically-deprived boroughs in the capital city)
High land prices which increases the cost of acquiring land for new property
development
Higher wage costs when employing skilled workers in the construction industry
The impact of high speculative demand for new properties in London especially
from overseas buyers
DEMAND
What is meant by demand?
Demand is the quantity of a good or service that consumers are willing and able
to buy at a given price in a given time period.
Each of us has an individual demand for particular goods and services and our
demand at each price reflects the value that we place on a product, linked usually
to the enjoyment or usefulness that we expect from consuming it. Economists
give this a term - utility
Effective demand
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Demand is different to desire! Effective demand is when a desire to buy a product is
backed up by an ability to pay for it
Latent Demand
Latent demand exists when there is willingness to buy among people for a good or
service, but where consumers lack the purchasing power to be able to afford the
product.
Derived Demand
The demand for a product X might be connected to the demand for a related product Y
giving rise to the idea of a derived demand. For example, demand for steel is strongly
linked to the demand for new vehicles and other manufactured products, so that when
an economy goes into a recession, so we expect the demand for steel to decline likewise.
Steel is a cyclical industry which means that market demand for steel is affected by
changes in the economic cycle and also by fluctuations in the exchange rate.
The demand for new bricks is derived from the demand for the final output of the
construction industry- when there is a recovery in the British building industry, so the
market demand for bricks will increase
Zinc is a good example of a product with a strong derived demand. It has a wide-range
of end uses such as galvanised zinc used in cars and new buildings, die-casting used in
door furniture and toys, brass and bronze used in taps and pipes. And also rolled zinc
(used in roofing, guttering and batteries) and in chemicals used in making tyres and zinc
cream.
The Law of Demand
There is an inverse relationship between the price of a good and demand.
As prices fall, we see an expansion of demand.
If price rises, there will be a contraction of demand.
Ceteris paribus assumption
Many factors affect demand. When drawing a demand curve, economists assume all
factors are held constant except one the price of the product itself. Ceteris paribus
allows us to isolate the effect of one variable on another variable
The Demand Curve
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A demand curve shows the relationship between the price of an item and the quantity
demanded over a period of time. There are two reasons why more is demanded as price
falls:
The Income Effect: There is an income effect when the price of a good falls because the
consumer can maintain the same consumption for less expenditure. Provided that the
good is normal, some of the resulting increase in real income is used to buy more of this
product.
The Substitution Effect: There is a substitution effect when the price of a good falls
because the product is now relatively cheaper than an alternative item and some
consumers switch their spending from the alternative good or service.
As price falls, a person switches away from rival products towards the product
As price falls, a persons willingness and ability to buy the product increases
As price falls, a persons opportunity cost of purchasing the product falls
Note: Many demand curves are drawn as straight lines to make the diagrams
easier to interpret.
Production Possibility Frontier ("PPF")
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A production possibility frontier (PPF) is a curve or a boundary which shows the
combinations of two or more goods and services that can be produced whilst using all of
the available factor resources efficiently.
We normally draw a PPF on a diagram as concave to the origin. This is because the
extra output resulting from allocating more resources to one particular good may fall.
I.e. as we move down the PPF, as more resources are allocated towards Good Y, the
extra output gets smaller and more of Good X has to be given up in order to produce
the extra output of Good Y. This is known as the principle of diminishing returns.
Diminishing returns occurs because not all factor inputs are equally suited to producing
different goods and services.
Combinations of output of goods X and Y lying inside the PPF occur when there
are unemployed resourcesor when the economy uses resources inefficiently. In the
diagram above, point X is an example of this. We could increase total output by moving
towards the production possibility frontier and reaching any of points C, A or B.
Point D is unattainable at the moment because it lies beyond the PPF. A country would
require an increase in factor resources, or an increase in the efficiency (or
productivity) of factor resources or animprovement in technology to reach this
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combination of Good X and Good Y. If we achieve this then output combination D may
become attainable.
Producing more of both goods would represent an improvement in our economic
welfare providing that the products are giving consumers a positive satisfaction and
therefore an improvement in what is calledallocative efficiency
Reallocating scarce resources from one product to another involves an opportunity cost.
If we go back to the previous PPF diagram, if we increase our output of Good X (i.e. a
movement along the PPF from point A to point B) then fewer resources are available to
produce good Y. Because of the shape of the PPF the opportunity cost of switching
resources increases i.e. we have to give up more of Good Y to achieve gains in the
output of good X.
The PPF does not always have to be drawn as a curve. If the opportunity cost for
producing two products is constant, then we draw the PPF as a straight line. The
gradient of that line is a way of measuring the opportunity cost between two goods.
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Explaining Shifts in the Production Possibility Frontier
The production possibility frontier will shift when:
o
There are improvements in productivity and efficiency perhaps because of the
introduction of new technology or advances in the techniques of production)
More factor resources are exploited perhaps due to an increase in the size of the
workforce or a rise in the amount of capital equipment available for businesses
In the diagram below, there is an improvement in technology which shifts the PPF
outwards. As a result of this, output possibilities have increased and we can conclude
(providing the good provides positive satisfaction to consumers) that there is an
improvement in economic welfare.
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Technology, prices and consumer welfare
Improved technology should bring market prices down and make products more
affordable to the consumer. This has been the case in the market for personal computers
and digital products. The exploitation of economies of scale and improvements in
production technology has brought prices down for consumers and businesses.
External Costs
In the case of air pollution there is an external cost to society arising from the
contamination of our air supplies. External costs are those costs faced by a third party
for which no compensation is forthcoming. Identifying and then estimating a monetary
value for air pollution can be a very difficult exercise but one that is important for
economists concerned with the impact of economic activity on our environment. We will
consider this issue in more detail when we study externalities and market failure.
Free Goods
Not all goods have an opportunity cost. Free goods are not scarce and no cost is involved
when consuming them.
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Is fresh air an example of a free good? Usually the answer is yes yet we know that air
can become contaminated by pollutants. And, in thousands of offices, shops and schools,
air-conditioning systems cool the air before it is consumed. With air conditioning,
scarce resources are used up in providing the product for example the capital
machinery and technology that goes into manufacturing the air conditioning
equipment; the labour involved in its design, production, distribution and maintenance
and the energy used up in powering the system.
Cool air might appear to be free but in fact it is often an expensive product to supply!
Specialisation and trade
Specialisation is when we concentrate on a product or task. Specialisation happens at all
levels:
The specialization of tasks within extended families in many of the worlds
poorest countries
Within businesses and organizations
In a country Bangladesh is a major producer and exporter of textiles; Norway
is a leading oil exporter. And Ghana is one of the biggest producers of cocoa in
the world.
In a region of a country for many years the West Midlands has been a centre
for motor car assembly, there has been huge investment in recent years in the
Mini plant at Oxford
What are the possible gains from specialization?
By concentrating on what people and businesses do best rather than relying on self
sufficiency:
Higher output: Total production of goods and services is raised and quality can
be improved
Variety; Consumers have access to a greater variety of higher quality products
A bigger market: Specialisation and global trade increase the size of the market
offering opportunities for economies of scale
Competition and lower prices: Increased competition acts as an incentive to
minimise costs, keep prices down and therefore maintains low inflation
The Division of Labour
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The division of labour occurs where production is broken down into many separate
tasks. Division of labour raises output per person as people become proficient through
constant repetition of a task learning by doing. This gain in productivity helps to
lower cost per unit and ought to lead to lower prices for consumers.
1. Unrewarding, repetitive work that requires little skill lowers motivation and
hits productivity. Workers begin to take less pride in their work and quality
suffers. We often see dissatisfied workers becoming less punctual at work and the
rate of absenteeism increases.
2. Many people may choose to move to less boring jobs creating a problem of high
worker turnover for businesses. In 2010, the overall employee turnover rate for
the UK was 13.5% per year, nearly one worker in seven changes jobs each year.
The highest labour turnover is found in retailing, hotels, catering and leisure, call
centres and among other lower paid private sector services groups
3. Some workers receive little training and may not be able to find alternative jobs
if they find themselves out of work - they may then suffer structural
unemployment.
4. Another disadvantage is that mass-produced standardized goods tend to lack
variety for consumers
Comparative advantage and the gains from specialisation and trade
Countries will usually specialise in and export products, which use intensively the
factors inputs, which they are most abundantly endowed. For example the Canadian
economy which is rich in low cost land is able to exploit this by specializing in
agricultural production. The dynamic Asian economies including
China has focused their resources in exporting low-cost manufactured goods which take
advantage of much lower labour costs. This is now changing as China looks to move
from a middle-income country by specializing in industries that use higher levels of
knowledge and technology.
In highly developed countries, the comparative advantage is shifting towards
specializing in producing and then exporting high-value and high-technology
manufactured goods and high-knowledge services.
The PPF and the effects of specialisation
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Two countries are producing two products (X and Y). With a given amount of
resources:
Output of X
Output of Y
Country A
180
90
Country B
200
150
In this example, country B has an absolute advantage in both products. Absolute
advantage occurs when a country or region can create more of a product with the same
factor inputs. But Country A has a comparative advantage in the production of good X.
It is 9/10ths as efficient at producing good X but it is only 3/5ths as efficient at
producing good Y.
Comparative advantage exists when a country has lower opportunity cost, i.e., it gives
up less of one product to obtain more of another product. In our example above, for
country A, every extra unit of good Y produced involves an opportunity cost of 2 unit of
good X. For country B, an additional unit of good Y involves a sacrifice of only 4.3 units
of good X.
There are gains to be had from country A specializing in the supply of good X and
country B allocating more of their resources into the production of good Y.
Another example of comparative advantage
Consider two countries producing two products digital cameras and vacuum cleaners.
Pre-specialisation
Digital Cameras
Vacuum Cleaners
UK
600
600
United States
2400
1000
Total
3000
1600
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Were the UK to shift more resources into higher output of vacuum cleaners, the
opportunity cost of each cleaner is one digital television. For the United States the same
decision has an opportunity cost of 2.4 digital cameras. Therefore, the UK has a
comparative advantage in vacuum cleaners.
If the UK chose to reallocate resources to digital cameras the opportunity cost of one
extra camera is still one vacuum cleaner. But for the United States the opportunity cost
is only 5/12ths of a vacuum cleaner. Thus the United States has a comparative
advantage in producing digital cameras.
Digital Cameras
Vacuum Cleaners
UK
0 (-600)
1200 (+600)
United States
3360 (+960)
600 (-400)
Total
3000
3360
1600
1800
The UK specializes totally in producing vacuum cleaners doubling its output to
1200.
The United States partly specializes in digital cameras increasing output by 960
having given up 400 units of vacuum cleaners.
Output of both products has increased - representing a gain in economic welfare.
For mutually beneficial trade to take place, the two nations have to agree an acceptable
rate of exchangeof one product for another. There are gains from trade between the two
countries. If the two countries trade at a rate of exchange of 2 digital cameras for one
vacuum cleaner, the post-trade position will be as follows:
o
The UK exports 420 vacuum cleaners to the USA and receives 840 digital
cameras
The USA exports 840 digital cameras and imports 420 vacuum cleaners
Digital Cameras
Vacuum Cleaners
UK
840
780
United States
2520
1020
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Total
3360
1800
Compared with the pre-specialisation output levels, consumers in both countries now
have an increased supply of both goods to choose from.
We have seen in this chapter how specialisation and trade based on the idea of
comparative advantage can lead to an improvement in welfare.
supply
Definition of Supply
Supply is defined as the quantity of a product that a producer is willing and able to
supply onto the market at a given price in a given time period.
Note: Throughout this study companion, the terms firm, business, producer and seller
have the same meaning.
The basic law of supply is that as the price of a commodity rises, so producers expand
their supply onto the market. A supply curve shows a relationship between price and
quantity a firm is willing and able to sell.
A supply curve is drawn assuming ceteris paribus - ie that all factors influencing supply
are being held constant except price. If the price of the good varies, we move along a
supply curve. In the diagram above, as the price rises from P1 to P2 there is
an expansion of supply. If the market price falls from P1 to P3 there would be
a contraction of supply in the market. Businesses are responding to price signals when
making their output decisions.
Explaining the Law of Supply
There are three main reasons why supply curves for most products are drawn as sloping
upwards from left to right giving a positive relationship between the market price and
quantity supplied:
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1. The profit motive: When the market price rises (for example after an increase in
consumer demand), it becomes more profitable for businesses to increase their
output. Higher prices send signals to firms that they can increase their profits by
satisfying demand in the market.
2. Production and costs: When output expands, a firms production costs rise,
therefore a higher price is needed to justify the extra output and cover these
extra costs of production.
3. New entrants coming into the market: Higher prices may create an incentive for
other businesses to enter the market leading to an increase in supply.
Shifts in the Supply Curve
The supply curve can shift position. If the supply curve shifts to the right (from S1 to
S2) this is an increase in supply; more is provided for sale at each price. If the supply
curve moves inwards from S1 to S3, there is a decrease in supply meaning that less will
be supplied at each price.
Changes in the costs of production
Lower costs of production mean that a business can supply more at each price. For
example a magazine publishing company might see a reduction in the cost of its
imported paper and inks. A car manufacturer might benefit from a stronger exchange
rate because the cost of components and new technology bought from overseas becomes
lower. These cost savings can then be passed through the supply chain to wholesalers
and retailers and may result in lower market prices for consumers.
Conversely, if the costs of production increase, for example following a rise in the price
of raw materials or a firm having to pay higher wages to its workers, then businesses
cannot supply as much at the same price and this will cause an inward shift of the
supply curve.
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A fall in the exchange rate causes an increase in the prices of imported components and
raw materials and will (other factors remaining constant) lead to a decrease in supply in
a number of different markets and industries. For example if the pounds falls by 10%
against the Euro, then it becomes more expensive for British car manufacturers to
import their rubber and glass from Western European suppliers, and higher prices for
paints imported from Eastern Europe.
Changes in production technology
Production technologies can change quickly and in industries where technological
change is rapid we see increases in supply and lower prices for the consumer.
Government taxes and subsidies
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Changes in climate
For commodities such as coffee, oranges and wheat, the effect of climatic conditions can
exert a great influence on market supply. Favourable weather will produce a bumper
harvest and will increase supply. Unfavourable weather conditions will lead to a poorer
harvest, lower yields and therefore a decrease in supply.
Changes in climate can therefore have an effect on prices for agricultural goods such as
coffee, tea and cocoa. Because these commodities are often used as ingredients in the
production of other products, a change in the supply of one can affect the supply and
price of another product. Higher coffee prices for example can lead to an increase in the
price of coffee-flavoured cakes. And higher banana prices as we see in the article below,
will feed through to increased prices for banana smoothies in shops and cafes.
Change in the prices of a substitute in production
A substitute in production is a product that could have been produced using the same
resources. Take the example of barley. An increase in the price of wheat makes wheat
growing more financially attractive. The profit motive may cause farmers to grow more
wheat rather than barley.
The number of producers in the market and their objectives
The number of sellers (businesses) in an industry affects market supply. When new
businesses enter a market, supply increases causing downward pressure on price.
Competitive Supply
Goods and services in competitive supply are alternative products that a business could
make with its factor resources of land, labour and capital. For example a farmer can
plant potatoes or maize.
equilibrium price
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Equilibrium means a state of equality or balance between market demand and supply
Without a shift in demand and/or supply there will be no change in price. In the
diagram above, the quantity demanded and supplied at price P1 are equal. At price P3,
supply exceeds demand and at P2, demand exceeds supply.
Prices where demand and supply are out of balance are termed points of
disequilibrium.
Changes in the conditions of demand or supply will cause changes in the equilibrium
price and quantity in the market.
Demand and supply schedules can be represented in a table. The weekly demand and
supply schedules for T-shirts (in thousands) in a city are shown in the next table:
Price per unit ()
Demand (000s)
10
12
14
16
18
20
Supply (000s)
18
16
14
12
10
New Demand
(000s)
10
12
14
16
18
20
22
24
New Supply (000s) 26
24
22
20
18
16
14
12
The equilibrium price is 5 where demand and supply are equal at 12,000 units
If the current market price was 3 there would be excess demand for 8,000
units
If the current market price was 8 there would be excess supply of 12,000 units
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ECONOMICS
A-LEVEL edexcel (Multiple choice & Essays)
A rise in income causes demand to rise by 4,000 at each price. The next row of
the table shows the higher level of demand. Assuming that the supply schedule
remains unchanged, the new equilibrium price is 6 per tee shirt with an
equilibrium quantity of 14,000 units
The entry of new producers into the market causes a rise in supply of 8,000 Tshirts at each price. The new equilibrium price becomes 4 with 18,000 units
bought and sold
Diagrams to show Changes in Market Demand and Equilibrium Price
The outward shift in the demand curve causes an expansion along the supply
curve and a rise in theequilibrium price and quantity. Firms in the market will
sell more at a higher price and therefore receive more total revenue
The reverse effects will occur when there is an inward shift of demand
A shift in the demand curve does not cause a shift in the supply curve!
Demand and supply factors are usually assumed to be independent of each other
although some economists claim this assumption is no longer valid!
Equilibrium price represents a trade-off for buyer and seller higher prices are
good for the producer (higher revenues and profits) but they make the product
more expensive for the buyer
AS INIT 1 : MARKETS
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ECONOMICS
A-LEVEL edexcel (Multiple choice & Essays)
Changes in Market Supply and Equilibrium Price
Important note for the exams:
A shift in the supply curve does not cause a shift in the demand curve. Instead we move
along (up or down) the demand curve to the new equilibrium position.
To really understand this topic it is essential for you to understand the difference
between shifts and movements along demand and supply curves
The equilibrium price and quantity in a market will change when there shifts in both
market supply and demand. Two examples of this are shown in the next diagram:
In the left-hand diagram above, we see an inward shift of supply together with a fall in
demand. Both factors lead to a fall in quantity traded, but the rise in costs forces up the
market price.
The second example on the right shows a rise in demand from D1 to D3 but a much
bigger increase in supply from S1 to S2. The net result is a fall in equilibrium price
(from P1 to P3) and an increase in the equilibrium quantity traded in the market from
Q1 to Q3.
Moving from one market equilibrium to another
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ECONOMICS
A-LEVEL edexcel (Multiple choice & Essays)
Changes in equilibrium prices and quantities do not happen instantaneously!
The shifts in supply and demand outlined in the diagrams before are reflective of
changes in conditions in the market.
So an outward shift of demand (depending upon supply conditions) leads to a
short term rise in price and a fall in available stocks.
The higher price is an incentive for suppliers to raise their output (termed as an
expansion of supply) causing a movement up the short term supply curve
towards the new equilibrium point.
Diagrams are a simplification of reality!
We tend to use supply and demand diagrams to illustrate movements in market
prices and quantities this is known as comparative static analysis
The reality in most markets and industries is more complex. For a start, many
businesses have imperfect knowledge about their demand curves they do not
know precisely how consumer demand reacts to changes in price or the true level
of demand at each and every price
Likewise, constructing accurate supply curves requires detailed information on
production costs and these may not be readily available.
Regulated prices
Not all prices are set by the free-market forces of supply and demand. In Britain, a
number of prices are affected by industry regulators good examples are rail fares, the
cost of postage stamps and water bills.
In the rail market, some of the fares are unregulated allowing train operating
companies to set their own prices. But around half of the fares charged for UK rail
travellers are determined by the rail regulator
You can see from the chart below that average rail fares in the UK have grown faster
than the overall consumer price index. The result is that the real cost or price of travel
has increased over recent years.
Here is a summary when there is a unique change in one of the conditions of market
demand or supply
Shift
Equilibrium Price
Equilibrium Quantity
Demand increases
Higher
Higher
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ECONOMICS
A-LEVEL edexcel (Multiple choice & Essays)
Demand decreases
Lower
Lower
Supply increases
Lower
Higher
Supply decreases
Higher
Lower
The possible outcomes for price and quantity are less certain when there is more than
one change in demand and supply conditions
(+) signifies increase in demand / supply
signifies no change in conditions of demand / supply
(-) signifies a fall in demand / supply
The outcome for market price is often uncertain because it depends on the size of the
relative changes in supply and demand in a given time period.
For example:
A 20% rise in demand and a 8% rise in supply will cause prices to rise
A 10% rise in demand and a 30% rise in supply will cause prices to fall
A 25% rise in demand and a 25% rise in supply will cause prices to remain
constant
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