Economics (0455) | Price determination

Welcome to the World of Price Determination!

Hello Economists! This chapter is incredibly important because it reveals the secret mechanism that runs a market economy: how prices are actually decided. Don't worry if you struggled with Demand and Supply curves individually—we are now putting them together!

Understanding Price Determination (or finding the Equilibrium Price) is like figuring out the perfect meeting point between what buyers want and what sellers are willing to offer. Once you master this, you have unlocked the core idea of how resources are allocated in free markets. Let’s dive in!

Quick Context: The Price Mechanism

Remember, in a market economy, the key decisions about what to produce, how to produce, and for whom to produce are answered by the Price Mechanism. Prices act as signals, telling producers where to move resources. This chapter explains how those signals (prices) are set.

1. Establishing Market Equilibrium (Topic 2.5.1)

Market Equilibrium occurs when the quantity that consumers demand is exactly equal to the quantity that producers are willing to supply. It is the perfect balance point in the market.

Key Term: Equilibrium Price and Quantity

Equilibrium Price (P\(*\)):
The price at which Demand equals Supply. This is also known as the Market Clearing Price because at this price, everything supplied is bought, leaving no surplus or shortage.

Equilibrium Quantity (Q\(*\)):
The amount bought and sold at the equilibrium price.

1.1 Using Demand and Supply Schedules

A Demand and Supply Schedule is simply a table that lists the quantity demanded (QD) and quantity supplied (QS) at different price levels.

Example: The Market for Coffee Mugs

Price per Mug (\(\$\))	Quantity Demanded (QD)	Quantity Supplied (QS)	Result
10	20	80	Surplus
8	30	60	Surplus
6	40	40	EQUILIBRIUM
4	55	25	Shortage
2	70	10	Shortage

Look closely at the table above. At a price of \(\$6\), buyers want 40 mugs, and sellers offer 40 mugs. The market is happy!

1.2 Using Demand and Supply Curves

When we plot the data from the schedule onto a graph, we get the familiar Demand (D) and Supply (S) curves.

The golden rule for the diagram:

• The Demand curve slopes downwards (D is for Down).
• The Supply curve slopes upwards (S is for Skywards).
• The Equilibrium Point is where the D curve and the S curve intersect (cross).

(Imagine a diagram where the D curve crosses the S curve. The intersection point is labelled E, corresponding to P* on the Y-axis and Q* on the X-axis.)

2. Market Disequilibrium: Shortages and Surpluses (Topic 2.5.2)

Market Disequilibrium occurs when the market price is NOT the equilibrium price, meaning that the quantity demanded does not equal the quantity supplied.

2.1 Scenario 1: Shortages (Excess Demand)

A Shortage happens when the price is below the equilibrium price.

Definition: Quantity Demanded is greater than Quantity Supplied (QD > QS).

Analogy: Concert Tickets
Imagine a concert promoter sets the ticket price too low (say, \(\$40\)). Hundreds of people want tickets (High QD), but only a limited number are available (Low QS). There is a long queue and disappointment. This is a shortage.

How does the market correct itself? (The self-correction mechanism):

1. Producers see massive demand and empty shelves (or long queues).
2. They realise they can charge more and still sell everything.
3. The price is pushed up by competition among consumers.
4. As the price rises, demand falls (contraction of demand) and supply increases (extension of supply), moving the market back towards equilibrium (P*).

2.2 Scenario 2: Surpluses (Excess Supply)

A Surplus happens when the price is above the equilibrium price.

Definition: Quantity Supplied is greater than Quantity Demanded (QS > QD).

Analogy: Winter Coat Sales in Summer
A clothes store keeps selling heavy winter coats at a high price (\(\$200\)) during the summer. They have lots of stock (High QS), but no one wants to buy them (Low QD). The coats pile up. This is a surplus.

How does the market correct itself?

1. Producers see stock piling up and generating no income.
2. They realise they must lower the price to attract buyers (often called a 'sale' or 'discount').
3. The price is pushed down.
4. As the price falls, demand increases (extension of demand) and supply decreases (contraction of supply), moving the market back towards equilibrium (P*).

3. Causes and Consequences of Price Changes (Topic 2.6)

The equilibrium price (P*) and quantity (Q*) only change when one of the market curves (Demand or Supply) shifts. This shift is caused by a change in the conditions of Demand (2.3.4) or conditions of Supply (2.4.4).

3.1 Analysing Changes in Demand

A shift in the Demand curve (due to factors like income, taste, or price of substitutes) causes the equilibrium point to move along the existing Supply curve.

Step-by-step: An Increase in Demand

1. Cause: Consumers’ income rises, so they want more normal goods (a condition of demand changes).
2. Shift: The Demand curve shifts right (D1 to D2).
3. Initial Effect (Disequilibrium): At the old price (P1), QD is now greater than QS. A shortage exists.
4. Consequence (New Equilibrium): The shortage pushes the price up. The new equilibrium price (P2) is higher, and the new equilibrium quantity (Q2) is higher.

Common Mistake Alert!
Do not confuse a shift in the *curve* (a change in demand) with a movement *along* the curve (a change in quantity demanded caused by price). A shift is always caused by a non-price factor.

Step-by-step: A Decrease in Demand

1. Cause: A major news report advises people against eating a certain food (change in tastes).
2. Shift: The Demand curve shifts left (D1 to D2).
3. Initial Effect (Disequilibrium): At the old price (P1), QS is now greater than QD. A surplus exists.
4. Consequence (New Equilibrium): The surplus forces the price down. The new equilibrium price (P2) is lower, and the new equilibrium quantity (Q2) is lower.

3.2 Analysing Changes in Supply

A shift in the Supply curve (due to factors like production costs or technology) causes the equilibrium point to move along the existing Demand curve.

Step-by-step: An Increase in Supply

1. Cause: New technology dramatically lowers the cost of producing mobile phones (a condition of supply changes).
2. Shift: The Supply curve shifts right (S1 to S2).
3. Initial Effect (Disequilibrium): At the old price (P1), QS is now greater than QD. A surplus exists.
4. Consequence (New Equilibrium): The surplus forces the price down. The new equilibrium price (P2) is lower, and the new equilibrium quantity (Q2) is higher.

Did you know?
This is often the situation in the technology industry (laptops, TVs). Improvements in technology constantly increase supply, which results in lower prices and higher sales for consumers over time.

Step-by-step: A Decrease in Supply

1. Cause: A natural disaster destroys key raw materials, making production expensive or impossible (e.g., a drought for agricultural products).
2. Shift: The Supply curve shifts left (S1 to S2).
3. Initial Effect (Disequilibrium): At the old price (P1), QD is now greater than QS. A shortage exists.
4. Consequence (New Equilibrium): The shortage pushes the price up. The new equilibrium price (P2) is higher, and the new equilibrium quantity (Q2) is lower.

Summary Table of Shifts and Consequences

Always practice drawing these diagrams! They are essential for demonstrating your understanding in the exam.

Event	Curve Shift	Consequence for Price (P)	Consequence for Quantity (Q)
Increase in Demand	D shifts RIGHT	Rises (\(\uparrow\))	Rises (\(\uparrow\))
Decrease in Demand	D shifts LEFT	Falls (\(\downarrow\))	Falls (\(\downarrow\))
Increase in Supply	S shifts RIGHT	Falls (\(\downarrow\))	Rises (\(\uparrow\))
Decrease in Supply	S shifts LEFT	Rises (\(\uparrow\))	Falls (\(\downarrow\))