2. The price system and the microeconomy

Effective demand is the quantity of a good or service consumers are willing and able to purchase at a particular price and time. Desire alone is not demand if purchasing power or access is absent.

A demand schedule links price to quantities demanded, holding other relevant factors constant. Income, expectations, tastes and related-good prices can change demand at every price.

A student may want a laptop but becomes an effective demander only when they can pay or obtain finance at the stated price.

A social-media wish list measures desire, not necessarily effective demand; ability to pay and a chosen price matter.

An individual demand curve shows one consumer’s quantities demanded at different prices; a market demand curve sums the quantities demanded by all consumers at each price. The same horizontal summation applies to supply.

Market curves depend on the number and characteristics of buyers or sellers. A change in the population or firms can change the market curve even if each individual curve is unchanged.

At £2, three consumers demand 2, 1 and 4 units, so market demand is 7 units at £2.

Do not add prices vertically for ordinary market demand and supply; add quantities at the same price.

Demand is influenced by income, tastes and preferences, prices of substitutes and complements, expectations, population and other relevant conditions, as well as the good’s own price.

A change in own price causes movement along a fixed demand curve; a change in another determinant shifts the whole curve because quantity demanded changes at every price.

Higher income may shift demand for a normal good right, while a fall in the price of a complement such as printer ink can increase demand for printers.

“Demand increased” should not be used for a movement along the curve unless the context distinguishes demand from quantity demanded.

Supply is influenced by input costs, technology, taxes and subsidies, the number of firms, prices of related outputs, expectations and natural conditions, as well as the good’s own price.

A determinant that changes the amount firms are willing to sell at every price shifts supply. Lower costs or better technology usually shift supply right; higher costs shift it left.

A subsidy for solar panels lowers effective production cost and can shift their supply curve right; a rise in semiconductor prices can shift smartphone supply left.

A higher market price causes movement along supply, not necessarily a rightward supply shift.

A demand shift means consumers want a different quantity at every possible price. It is caused by a determinant such as income, tastes, expectations or a related good’s price, not by the good’s own price.

For a normal good, higher income usually shifts demand right; for an inferior good it may shift demand left. Use the good’s classification and the direction of the determinant.

If consumers expect petrol prices to rise next month, current demand may shift right as they buy more now, even though today’s petrol price is unchanged.

A right shift does not mean quantity demanded rises at only one price; it changes the whole relationship.

A supply shift means firms offer a different quantity at every price because production conditions changed. Technology, input costs, taxes, subsidies, weather, firm numbers and expectations are common causes.

A right shift represents greater supply at each price; a left shift represents less. The direction must follow the mechanism, not a memorised list.

A drought can shift agricultural supply left; a productivity-improving irrigation system can shift it right, though the final effect may depend on costs and scale.

A rise in the product’s own price is not by itself a supply shift; it is a movement along supply.

A movement along demand or supply follows a change in the good’s own price. A shift changes the entire curve because another determinant changes.

Ask two questions: did the product’s price change, and did willingness to buy or sell change at every price? The second indicates a shift.

A higher coffee price moves consumers up the same demand curve; a change in the price of tea, a substitute, shifts coffee demand.

Do not draw an arrow along a curve when the question changes income, costs, tastes or technology; those are shift factors.

Price elasticity of demand (PED) measures quantity demanded’s response to price; income elasticity (YED) measures response to income; cross elasticity (XED) measures response to another good’s price.

PED compares a good with its own price, YED with consumer income and XED with a related good. Keep the numerator and denominator matched to the concept.

A fall in the price of a product may change its quantity demanded (PED), while a rise in income may increase demand for a normal good (YED).

Elasticity is not a slope alone: it is a percentage response relative to a percentage change.

PED = % change in quantity demanded / % change in price; YED = % change in quantity demanded / % change in income; XED = % change in demand for A / % change in price of B.

Use a consistent percentage-change method, state the sign and interpret the magnitude. For a finite interval, the midpoint method may avoid choosing one endpoint as the base.

If price rises 10% and quantity demanded falls 20%, PED = −2. A 5% income rise that increases demand 2% gives YED = 0.4.

Do not divide an absolute quantity change by a percentage price change; both parts must be percentage changes.

The sign identifies the direction of the relationship: PED is usually negative, YED is positive for normal goods and negative for inferior goods, and XED is positive for substitutes and negative for complements.

The absolute size measures responsiveness: values above one are elastic, below one inelastic and equal to one unitary. Sign and magnitude must both be reported.

XED = +0.6 suggests substitutes but a relatively weak response; YED = −1.2 suggests an inferior good with more-than-proportional fall in demand as income rises.

A coefficient of −2 is not “less elastic” than +1 because of its sign; compare absolute values for responsiveness.

Perfectly elastic demand has an infinitesimal price change causing an enormous quantity response; perfectly inelastic demand has zero quantity response. Elastic, unitary and inelastic lie between these extremes according to |coefficient| greater than, equal to or less than one.

The label applies to the relevant section or point of the curve, not automatically to the whole market. Revenue implications depend on which side of unit elasticity demand lies.

A PED of −1.5 is elastic; −1.0 is unitary; −0.4 is inelastic. A vertical demand curve is perfectly inelastic in the diagram.

“Elastic” does not mean quantity changes without limit; it means the percentage response is greater than the percentage price change.

Even though the slope of a straight-line demand curve is constant, PED changes along it because elasticity uses percentage changes relative to the current price and quantity.

Near the high-price/low-quantity end, a small quantity change is large relative to quantity, so demand is more elastic. Near the low-price/high-quantity end, it is more inelastic; the midpoint is unitary in the standard linear case.

Moving the same small amount along a linear demand curve can produce a larger percentage quantity response near the quantity intercept than near the price intercept.

Constant slope does not mean constant PED; slope and elasticity are different measures.

PED tends to be larger when close substitutes exist, the good is a luxury rather than a necessity, consumers have time to adjust, or the good takes a large share of income. YED and XED have their own category and relationship determinants.

These are tendencies, not automatic results: brand loyalty, habit, information and market definition can change the response.

Petrol may be inelastic in the short run when commuting alternatives are limited but more elastic in the long run as people change cars or routes.

Do not explain every elasticity solely by “necessity”; time horizon and available substitutes may dominate.

Total expenditure is price multiplied by quantity bought. If demand is elastic, a price rise reduces total expenditure because quantity falls proportionally more; if demand is inelastic, total expenditure rises.

With unitary elasticity, the percentage price and quantity changes offset and total expenditure is approximately unchanged. The result applies over the relevant section and direction of movement.

A 10% price rise with a 20% quantity fall lowers expenditure; a 10% price rise with only a 5% quantity fall raises it.

Do not decide from the price change alone: the demand response and the starting price/quantity determine expenditure.

PED informs pricing and total expenditure; YED helps forecast demand as incomes change; XED indicates how a rival or complement’s price may affect demand.

Use the sign and magnitude with the decision’s objective. A firm seeking revenue may raise price when demand is inelastic, while a government assessing a tax or subsidy must consider related goods and income effects.

A luxury retailer with positive YED may plan for stronger sales in an expansion; a bus operator may find a fare rise raises revenue only if demand is sufficiently inelastic.

Elasticity gives a conditional forecast, not a guaranteed profit result: costs, competition and capacity also matter.

Price elasticity of supply (PES) measures the percentage change in quantity supplied divided by the percentage change in the good’s own price.

A positive PES is usual because a higher price gives firms an incentive to supply more, but the response depends on spare capacity, stocks and how quickly inputs can adjust.

If price rises and firms can quickly add shifts, quantity supplied may respond strongly; a harvest crop with fixed output in the short run is less responsive.

PES concerns producers’ response to price, not consumers’ response to income or a shift in demand.

PES = % change in quantity supplied / % change in price. Substitute percentage changes consistently and report the coefficient with its interpretation.

For a finite change use the method specified by the question; the midpoint method can avoid endpoint bias. Keep the sign and units clear, although PES is often positive.

A 12% price increase causing an 18% rise in quantity supplied gives PES = 1.5, an elastic supply response.

Do not use the absolute change in output over the absolute change in price and call it PES; elasticity is a percentage ratio.

The PES sign shows whether quantity supplied moves with price; the absolute size shows how strongly. PES greater than one is elastic, equal to one unitary and below one inelastic.

A coefficient of 0.2 means output changes proportionally less than price; 2.0 means output changes proportionally more. Perfectly inelastic supply is vertical and perfectly elastic supply horizontal in the simple diagrams.

PES = 0.4 indicates an inelastic response, while PES = 1.3 indicates an elastic response.

Do not compare PES magnitudes without checking that the same time horizon and market definition are being used.

Supply tends to be more elastic when firms have spare capacity, can store goods, access mobile inputs, use flexible production methods or have a longer time to adjust.

Perishable goods, fixed land or specialist skills can make short-run supply inelastic. The market’s ability to attract new firms also affects long-run response.

Hotel rooms are nearly fixed tonight but new rooms can be built over years, so supply is more elastic in the long run.

A large stock of machinery does not guarantee elastic supply if skilled labour or raw materials remain fixed.

The speed and ease with which firms can change output determine how responsive supply is to a price change. Spare capacity, stocks, flexible inputs and easy entry raise PES.

A perishable crop or a fully occupied factory may be inelastic in the short run; storage, overtime or new firms can make the response more elastic later.

Concert seats available tonight are fixed, but a manufacturer can expand output over months by hiring and installing equipment.

A firm’s ability to change price is not the issue in PES; the issue is how quickly it can change quantity supplied.

Equilibrium occurs at the price and quantity where buyers’ quantity demanded equals sellers’ quantity supplied. A disequilibrium creates excess demand or excess supply.

If price is above equilibrium, a surplus puts downward pressure on price; if below, a shortage puts upward pressure, assuming prices can adjust.

At £5, buyers want 100 units and firms offer 100: equilibrium. At £3, demand may exceed supply, creating a shortage and pressure for price to rise.

Equilibrium does not mean the quantity is morally ideal or that nothing changes; it means the market-clearing condition at that moment.

A demand or supply shift changes the intersection of the curves. A rightward demand shift usually raises equilibrium price and quantity; a rightward supply shift usually lowers price and raises quantity, with the exact outcome depending on elasticities.

Draw the original and new curves, identify the new intersection, then explain the movement through shortage or surplus pressure.

A harvest failure shifts supply left, tending to raise food price and reduce quantity; a successful advertising campaign shifts demand right, tending to raise both.

Do not assume every demand shift raises quantity: a leftward shift lowers it, and simultaneous shifts can produce ambiguous outcomes.

A change in one market can affect another when goods are substitutes or complements, when firms share inputs, or when income and expectations transmit effects across markets.

Trace the direction: a price rise for a substitute can shift demand for the other good right; a price rise for a complement can shift it left; a shared input-cost increase can shift several supplies left.

A rise in petrol prices may reduce demand for large cars but increase demand for rail travel, while raising costs for delivery services.

Markets are not linked merely because products are both “consumer goods”; a specific relationship or shared constraint must be identified.

A price rations by limiting access when demand exceeds supply, signals information about scarcity and preferences, and incentivises consumers and producers to change behaviour.

The same price can perform all three functions, though distributional effects may make market rationing unequal. Taxes and subsidies alter incentives by changing relative prices.

A higher electricity price signals scarce supply, rations consumption and encourages households to insulate while attracting investment in generation.

A price signal is not a guarantee that every market participant receives complete information or can afford the good.

Consumer surplus is the extra benefit buyers receive when they pay less than the maximum price they were willing to pay. On a standard demand diagram it is the area below demand and above market price up to quantity traded.

A price fall usually increases consumer surplus through a gain on existing units and access to additional units, while a price rise reduces it.

If a buyer would pay £10 for a ticket but pays £7, their surplus is £3; summing across buyers gives market consumer surplus.

Consumer surplus is not the firm’s revenue and does not measure every aspect of welfare or fairness.

Producer surplus is the extra return sellers receive when the market price exceeds the minimum price at which they would supply each unit. On a supply diagram it is the area above supply and below price up to the quantity traded.

A price rise usually increases producer surplus through a gain on existing units and payment for additional units. Costs and supply elasticity affect the size of the change.

If a firm would supply a unit for £4 and sells it for £7, its surplus on that unit is £3.

Producer surplus is not total profit or revenue: it ignores fixed costs and other business expenses.

Consumer surplus changes when the price or demand conditions change; producer surplus changes when the price or supply conditions change. A diagram shows the areas gained or lost.

A demand increase tends to raise price and quantity, usually increasing both surpluses, while a supply reduction tends to raise price for buyers but may reduce total trades and producer surplus depending on the shift.

A subsidy that shifts supply right lowers price, increasing consumer surplus; producers may gain from more sales but lose on the lower price per existing unit.

Do not assume a lower price always reduces producer surplus or a higher price always increases total welfare; quantity and the curve shifts matter.

Elastic demand or supply means quantity responds strongly to price, while inelastic curves respond weakly. Their slopes and positions affect how much consumer and producer surplus change when equilibrium moves.

A flatter demand curve can create a large quantity response and a different surplus redistribution for the same price change. Use the diagram and elasticity together rather than treating “elastic” as automatically better.

A tax on a product with inelastic demand may raise price substantially with a smaller quantity fall, shifting more burden to consumers; with elastic demand, quantity contracts more.

Elasticity predicts responsiveness, not whether surplus rises for every group; the direction of price and quantity changes must be identified first.