Economics (9708) | The interaction of demand and supply

Economics (9708) Study Notes: The Interaction of Demand and Supply (AS Level, Topic 2.4)

Hello future Economist! This chapter is where the two major concepts you've already mastered—Demand and Supply—finally meet! This interaction forms the very heart of the microeconomy and is often called the price mechanism or the invisible hand. Understanding how these forces interact is essential because it explains how resources are allocated in a market economy. If you can master these shifts and concepts, you are well on your way to acing the paper!

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1. Market Equilibrium and Disequilibrium (2.4.1)

What is Equilibrium?

Imagine a tug-of-war where neither side is winning. That is the essence of market equilibrium. It is the perfect balance point in a market.

• Definition: Market Equilibrium occurs when the quantity demanded by consumers exactly equals the quantity supplied by producers.
• At this point, the market is "cleared"—there is no incentive for price to change.

The resulting price is the Equilibrium Price (P*) and the quantity traded is the Equilibrium Quantity (Q*).

Visualising Equilibrium

In a standard Demand and Supply diagram, equilibrium is found at the intersection of the Demand (D) curve and the Supply (S) curve.

(Imagine a diagram where D slopes down and S slopes up, meeting at P* and Q*.)

What is Disequilibrium?

Disequilibrium happens when the market price is NOT at P*. This causes imbalances, which trigger changes until the market moves back towards equilibrium.

A. Excess Supply (Surplus)

• When it occurs: The market price is set above the equilibrium price (P > P*).
• Effect: At the high price, producers want to supply a lot (\(Q_S\)), but consumers only want to demand a little (\(Q_D\)). Therefore, \(Q_S > Q_D\).
• Real-World Analogy: If a shop prices brand new video games too high, they will have stacks of unsold inventory left over.
• Market Response (The Fix): To get rid of the unsold stock, producers must drop the price. As the price falls, Quantity Demanded rises, and Quantity Supplied falls, until P* is reached again.

B. Excess Demand (Shortage)

• When it occurs: The market price is set below the equilibrium price (P < P*).
• Effect: At the low price, consumers want to buy a lot (\(Q_D\)), but producers are only willing to supply a little (\(Q_S\)). Therefore, \(Q_D > Q_S\).
• Real-World Analogy: If concert tickets are priced very cheaply, everyone wants one, but there are not enough seats for all the fans.
• Market Response (The Fix): The shortage means consumers are willing to pay more. Producers see the high demand and raise the price. As the price rises, Quantity Demanded falls, and Quantity Supplied rises, until P* is reached again.

Key Takeaway: The market is self-correcting. Surpluses push prices down, and shortages push prices up, always aiming back for the equilibrium point where D = S.

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2. Effects of Shifts on Equilibrium Price and Quantity (2.4.2)

Equilibrium only changes when one of the non-price determinants (the factors that cause the entire curve to shift) changes. We use P* and Q* notation to show the original equilibrium, and P1 and Q1 for the new equilibrium.

Scenario 1: Shifts in Demand

Remember, a shift in Demand is caused by changes in income, tastes, price of substitutes/complements, etc. (Determinants of Demand).

A. Increase in Demand (D shifts Right)

Example: A heatwave causes a massive increase in demand for ice cream.

Effect: The market moves from P* and Q* to a higher equilibrium.
New Equilibrium: P increases, Q increases.

B. Decrease in Demand (D shifts Left)

Example: A health report warns people against drinking too much coffee.

Effect: The market moves to a lower equilibrium.
New Equilibrium: P decreases, Q decreases.

Scenario 2: Shifts in Supply

Remember, a shift in Supply is caused by changes in costs of production, technology, taxes/subsidies, etc. (Determinants of Supply).

A. Increase in Supply (S shifts Right)

Example: New technology makes farming wheat cheaper and more efficient.

Effect: The market moves to a lower price but higher quantity.
New Equilibrium: P decreases, Q increases.

B. Decrease in Supply (S shifts Left)

Example: A sudden rise in the cost of oil increases transportation costs for all goods.

Effect: The market moves to a higher price but lower quantity.
New Equilibrium: P increases, Q decreases.

Scenario 3: Simultaneous Shifts (When both D and S shift)

Don't worry if this seems tricky at first! When both curves shift, we can determine the change in EITHER price OR quantity, but usually not both. One of them will be indeterminate (uncertain).

Example: Demand for cars increases (D shifts right), AND the cost of steel increases (S shifts left).

• D increases (P tends to rise, Q tends to rise).
• S decreases (P tends to rise, Q tends to fall).

Result: Since both shifts push price up, P definitely increases. But since D pushes Q up and S pushes Q down, the change in Q is indeterminate (it depends on which shift was bigger).

Key Takeaway: Single shifts have clear outcomes for P and Q. Simultaneous shifts mean one outcome (P or Q) is clear, and the other is uncertain.

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3. Relationships Between Different Markets (2.4.3)

Markets don't exist in isolation. A change in the market for one good often impacts the demand or supply curve of another good. We need to identify four key relationships:

A. Joint Demand (Complements)

• Definition: Goods that are consumed together (e.g., tea and sugar, console and games, smartphone and apps).
• Relationship: They are complements in consumption.
• Effect: If the price of Good A falls, Demand for Good B increases.

Example: If the price of coffee capsules falls, the demand curve for coffee machines will shift to the right (increase).

B. Alternative Demand (Substitutes)

• Definition: Goods that can be consumed or used in place of one another (e.g., butter and margarine, Pepsi and Coke, trains and buses).
• Relationship: They are substitutes in consumption.
• Effect: If the price of Good A falls, Demand for Good B decreases.

Example: If the price of Android phones falls significantly, the demand curve for iPhones will shift to the left (decrease).

C. Derived Demand

• Definition: Demand for a factor of production (e.g., labour, raw materials, land) that results from the demand for the final product it helps to make.
• Relationship: The demand for the input is 'derived' from the demand for the output.
• Effect: If Demand for the final product increases, Demand for the necessary factor of production increases.

Example: If the demand for new houses increases, the demand for construction workers and timber will increase.

D. Joint Supply

• Definition: Production process where two or more goods are produced simultaneously from the same resource or process (e.g., crude oil produces petrol, diesel, and kerosene; farming beef also produces leather hides).
• Relationship: They are complements in production.
• Effect: If the Supply of Good A increases, the Supply of Good B also increases.

Example: If the demand for lamb meat increases (driving up its price), farmers increase sheep production. This increase in the supply of lamb also leads to an increase in the supply of wool (a joint product).

Key Takeaway: Changes in one market can cause shifts (not movements) in the demand or supply curves of related markets.

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4. Functions of Price in Resource Allocation (The Price Mechanism) (2.4.4)

In a free market economy, prices do not just happen randomly; they have specific, powerful roles in deciding how resources (factors of production) are allocated. These roles are known as the functions of the price mechanism.

1. Signalling Function (Transmission of Preferences)

• What it does: Prices communicate essential information between consumers and producers.
• How it works: A rising price signals to producers that consumer demand is high (or supply is low) relative to demand. This indicates that resources should be moved into this market, as greater profits can be made.
• Conversely, a falling price signals lower demand or oversupply, telling firms to reallocate resources elsewhere.

Example: If the price of avocados suddenly spikes, this signals to avocado farmers that consumers really want this product and that the market needs more supply.

2. Incentivising Function

• What it does: Prices motivate economic agents (consumers and producers) to change their behaviour.
• How it works:
  • For Producers: A high price offers the incentive of higher profits, encouraging them to increase production.
  • For Consumers: A high price offers the incentive to reduce consumption or look for substitutes.

Example: When the price of electricity goes up dramatically, households are incentivised to use less energy and perhaps invest in solar panels.

3. Rationing Function

• What it does: Prices allocate scarce resources to those who are most willing and able to pay.
• How it works: When there is a shortage (excess demand), the rising price rations the available supply. Only those consumers who can afford the higher price and value the good most highly will buy it.

Example: During a drought, the price of fresh vegetables rises significantly. This rations the limited supply of vegetables, meaning only those who prioritize (and can afford) them will buy them.

Key Takeaway: Prices are the communication and motivational tools that ensure resources are directed to where consumer demand is greatest in a free market.