Notes · EconomicsUK · A-Levels

Price determination in a competitive market

This chapter develops the demand and supply model that is the engine of the whole subject. It covers the determinants of demand and supply and the difference between movements along and shifts of the curves, the three elasticities of demand and the elasticity of supply, the determination of equilibrium price, and the rationing, incentive and signalling functions of the price mechanism, together with consumer and producer surplus.

5 sections~23 min reading time4 competenciesLevel Foundation 1 · Standard 3 · Advanced 1

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Exam profile

AO1 · Define demand, supply, equilibrium, the elasticities and consumer and producer surplusAO2 · Apply demand and supply analysis and calculate and interpret elasticities from dataAO3 · Analyse how shifts in demand and supply change equilibrium price and quantityAO4 · Evaluate the significance of elasticity for firms and government and the strengths and limits of the price mechanism

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basic level

AS-Level requires demand and supply, the elasticities and their calculation, equilibrium and the functions of the price mechanism.

higher level

The full A-Level expects fluent shift analysis, application of elasticity to firm and government decisions, and evaluation of the price mechanism and of interrelated markets.

Depth

Text

Contents · 5 sections

Price determination in a competitive market

Demand and the determinants of demand#

FoundationAQA 7136 4.1.3DfE GCE Economics - the demand for goods and services

A shift of the demand curve versus a movement along it

Fig. 1A change in a NON-price determinant shifts the curve from D1 to D2 (an increase in demand); a change in the good's own price would be a movement along a single curve.

Demand is the quantity of a good or service that consumers are willing and able to buy at each given price over a period of time, other things being equal. It is 'effective' demand - backed by the ability to pay, not merely a want. The law of demand states that, ceteris paribus, as the price of a good rises the quantity demanded falls, and as price falls quantity demanded rises, giving the demand curve its downward slope. The chapter on individual decision making explained why: diminishing marginal utility, reinforced by the income effect (a price fall raises real purchasing power) and the substitution effect (the good becomes relatively cheaper than substitutes).

It is essential to distinguish a movement along a demand curve from a shift of the whole curve, because muddling the two is one of the most heavily penalised errors at A-Level. A change in the good's OWN PRICE causes a movement along the demand curve - an extension (more demanded at a lower price) or a contraction (less demanded at a higher price). A change in any OTHER determinant shifts the whole demand curve - to the right (an increase in demand) or to the left (a decrease).

The conditions of demand - the factors that shift the curve - are conveniently remembered by an acronym such as PIRATES: Population (size and structure), Income, Related goods (the prices of substitutes and complements), Advertising and tastes, Technology, Expectations (of future prices or income) and Seasons. For a normal good, a rise in income increases demand; for a substitute, a rise in its price increases demand for our good; for a complement, a rise in its price decreases demand for our good. Each of these shifts the entire curve, changing the quantity demanded at every price.

Understanding what shifts demand is the basis for all applied analysis. When a data-response extract reports, say, a fall in the price of a complementary good, a rise in average incomes, or a successful advertising campaign, the skill being tested is to identify the correct direction of the shift and then trace its effect on equilibrium price and quantity, which the equilibrium section develops. Always specify the direction of the shift (right = increase) and label the curves D1 and D2 on any diagram.

Worked example

Classifying determinants as shifts or movements

For the market for cinema tickets, classify each event as a movement along the demand curve or a shift, and state the direction: (i) cinema ticket prices fall; (ii) the price of home streaming subscriptions rises; (iii) average incomes fall in a recession.

Event (i)
A change in the good's OWN price causes a movement along the demand curve - an extension of demand (more tickets demanded at the lower price).
Event (ii)
Streaming is a substitute for cinema; a rise in its price shifts the demand for cinema tickets to the RIGHT (an increase in demand).
Event (iii)
Cinema tickets are a normal good; falling income shifts demand to the LEFT (a decrease in demand).

Result: Only the own-price change (i) is a movement along the curve; (ii) and (iii) are shifts, to the right and left respectively.

Typical mistakes

Saying demand 'increases' when the good's own price falls - that is an extension (movement along the curve), not an increase in demand (a shift).
Getting substitutes and complements the wrong way round - a rise in the price of a COMPLEMENT decreases demand for the good.

Active revision

Using a demand diagram, explain the effect on the demand for train travel of (a) a fall in the price of petrol and (b) a rise in rail fares. Identify in each case whether it is a shift or a movement along the curve.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

Elasticities of demand: PED, YED and XED#

StandardAQA 7136 4.1.3DfE GCE Economics - price, income and cross elasticities of demand

Elastic and inelastic demand curves

Fig. 2A steeper demand curve is more price inelastic (quantity responds little to price); a shallower curve is more elastic. The gradient is a guide, not the definition, of PED.

Elasticity measures the responsiveness of one variable to a change in another, expressed as a ratio of percentage changes so that it is a pure number, independent of units. The price elasticity of demand (PED) measures how responsive the quantity demanded of a good is to a change in its own price. Because demand slopes downwards, PED is normally negative; economists focus on its magnitude. If the magnitude exceeds 1, demand is price elastic (quantity is proportionately more responsive than price); if it is between 0 and 1, demand is price inelastic; if it equals exactly 1, demand is unit elastic. The determinants of PED include the availability and closeness of substitutes (more substitutes make demand more elastic), the proportion of income spent on the good, whether it is a necessity or a luxury, whether it is addictive, and the time period (demand is more elastic in the long run as consumers adjust).

PED matters intensely for pricing and for tax policy because of its link to total revenue (price times quantity). When demand is price inelastic, a rise in price raises total revenue, because the proportionate fall in quantity is smaller than the proportionate rise in price; when demand is price elastic, a rise in price lowers total revenue. This is why a firm selling a product with few substitutes can raise revenue by raising price, and why a government seeking to raise revenue taxes inelastic goods such as tobacco and fuel, whereas one seeking to cut consumption relies on demand being elastic enough over time.

The income elasticity of demand (YED) measures the responsiveness of quantity demanded to a change in real income. Its sign classifies the good: a positive YED indicates a normal good (demand rises with income), and within normal goods a YED greater than 1 marks a luxury (income elastic, demand rises more than proportionately) and a YED between 0 and 1 a necessity (income inelastic). A negative YED indicates an inferior good, for which demand falls as income rises because consumers switch to superior alternatives. Firms use YED to plan for the economic cycle - producers of luxuries are hit hard in a downturn, while inferior goods may see demand rise.

The cross elasticity of demand (XED) measures the responsiveness of the quantity demanded of one good to a change in the price of ANOTHER good, and its sign reveals the relationship between them. A positive XED indicates substitutes (a rise in the price of good B raises demand for good A), and the larger the value the closer the substitutes. A negative XED indicates complements (a rise in the price of B, used with A, lowers demand for A). An XED near zero indicates unrelated goods. Firms use XED to anticipate the effect of rivals' price changes and to understand the strength of complementary relationships in their product range.

PED = \frac{\%\,\Delta Q_d}{\%\,\Delta P}

Price elasticity of demand

Normally negative; |PED| > 1 elastic, |PED| < 1 inelastic, |PED| = 1 unit elastic. A rise in price raises total revenue when demand is inelastic and lowers it when demand is elastic.

YED = \frac{\%\,\Delta Q_d}{\%\,\Delta Y}

Income elasticity of demand

YED > 0 normal good (>1 luxury, 0-1 necessity); YED < 0 inferior good.

XED_{A,B} = \frac{\%\,\Delta Q_{d\,A}}{\%\,\Delta P_{B}}

Cross elasticity of demand

XED > 0 substitutes; XED < 0 complements; XED near 0 unrelated goods.

Worked example

Calculating and interpreting PED and YED

The price of a bus fare rises from 2.00 to 2.20 pounds and daily passengers fall from 1,000 to 950. Separately, when average income rises by 5%, demand for taxi rides rises by 15%. Find PED for bus travel and YED for taxis, and interpret each.

Percentage changes for the bus
%change in price = (2.20-2.00)/2.00 = +10%. %change in quantity = (950-1000)/1000 = -5%.
Compute and interpret PED
PED = -5% / +10% = -0.5. The magnitude is below 1, so bus demand is price INELASTIC; the fare rise therefore RAISES total revenue (from 2,000 to 2,090 pounds per day).
Compute and interpret YED
YED = +15% / +5% = +3. It is positive (a normal good) and greater than 1, so taxi rides are an income-elastic LUXURY - demand is very sensitive to the cycle.

Result: Bus travel has PED = -0.5 (inelastic, revenue rises with price); taxis have YED = +3 (a normal, luxury good).

Typical mistakes

Dropping the sign of YED or XED - the sign carries the economic meaning (inferior vs normal; complement vs substitute).
Inverting the elasticity formula (percentage change in price over quantity) - the responding variable (quantity) always goes on top.

Active revision

When a coffee shop raises its price by 10%, sales fall by 4%. Calculate the PED, state whether demand is elastic or inelastic, and explain what happens to total revenue.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

Supply and the price elasticity of supply#

StandardAQA 7136 4.1.3DfE GCE Economics - the supply of goods and services

The supply curve and an increase in supply

Fig. 3Supply slopes upward; a fall in costs, a subsidy or better technology shifts it right from S1 to S2 (an increase in supply).

Supply is the quantity of a good or service that producers are willing and able to sell at each given price over a period of time, other things being equal. The supply curve slopes upwards because a higher price makes production more profitable, encouraging existing firms to expand output and new firms to enter, and because rising marginal costs mean firms need a higher price to justify producing extra units. As with demand, a change in the good's OWN price causes a movement along the supply curve (an extension or contraction), while a change in any other determinant shifts the whole curve.

The conditions of supply - the factors that shift the curve - can be remembered by an acronym such as PINTSWC: Productivity, Indirect taxes (and subsidies), Number of firms, Technology, Subsidies, Weather (for agricultural goods) and Costs of production. A fall in costs, an improvement in technology, a subsidy or more firms entering all shift supply to the right (an increase in supply); a rise in costs or an indirect tax shifts it to the left (a decrease). Indirect taxes and subsidies are especially important because they shift supply by the amount of the tax or subsidy at each output, which underlies the analysis of government intervention.

The price elasticity of supply (PES) measures how responsive the quantity supplied is to a change in the good's own price. It is normally positive because supply slopes upwards. PES greater than 1 means supply is price elastic (quantity responds more than proportionately); PES between 0 and 1 means it is inelastic. Two special cases are perfectly inelastic supply (PES = 0, a vertical supply curve, quantity fixed regardless of price - as with a Rembrandt painting in the short run) and perfectly elastic supply (PES infinite, a horizontal curve).

The determinants of PES centre on how easily and quickly firms can vary output. Supply is more elastic when firms have spare productive capacity, when stocks of finished goods can be released, when factors of production are mobile and easily obtained, and when there is time to adjust - supply is more elastic in the long run than in the short run because in the long run firms can build new capacity. Perishability reduces elasticity (perishable goods cannot be stockpiled). PES matters because it determines how much of a demand change is absorbed by price rather than quantity: when supply is inelastic, a rise in demand mainly raises price (as in housing, where supply responds slowly).

PES = \frac{\%\,\Delta Q_s}{\%\,\Delta P}

Price elasticity of supply

Normally positive; PES > 1 elastic, PES < 1 inelastic, PES = 0 perfectly inelastic (vertical), PES infinite perfectly elastic (horizontal). Supply is more elastic in the long run.

Worked example

Calculating PES and reasoning about the time period

A factory raises output from 500 to 560 units when the price rises from 10 to 11 pounds. Calculate the PES and explain how it might differ over a longer period.

Percentage changes
%change in price = (11-10)/10 = +10%. %change in quantity supplied = (560-500)/500 = +12%.
Compute PES
PES = +12% / +10% = +1.2, which is greater than 1, so supply is price ELASTIC in this period - the firm has spare capacity to expand.
Reason about time
In the very short run, with capacity already near its limit, PES would be lower; over the long run, as the firm can invest in new plant and more firms enter, PES rises further - supply is most elastic in the long run.

Result: PES = +1.2 (elastic); supply becomes more elastic still in the long run as capacity can be expanded.

Typical mistakes

Confusing a shift of supply (a change in costs, tax or technology) with a movement along it (a change in the good's own price).
Assuming supply is always fairly elastic - agricultural and housing supply are often highly inelastic in the short run.

Active revision

When the price of wheat rises by 20%, the quantity supplied this season rises by only 4%. Calculate the PES, comment on its value, and explain why farm supply is often inelastic in the short run.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

Market equilibrium and the price mechanism#

StandardAQA 7136 4.1.3DfE GCE Economics - the determination of equilibrium prices

Market equilibrium

Fig. 4Equilibrium is where demand equals supply. Above it there is excess supply (a surplus); below it there is excess demand (a shortage).

Market equilibrium occurs at the price where the quantity demanded equals the quantity supplied - where the demand and supply curves intersect. At this equilibrium price there is no tendency for price to change, because there is neither excess demand nor excess supply. If the price is above equilibrium, quantity supplied exceeds quantity demanded, creating excess supply (a surplus) that pushes price down; if the price is below equilibrium, quantity demanded exceeds quantity supplied, creating excess demand (a shortage) that pushes price up. The market therefore tends automatically towards equilibrium, a self-correcting process driven by the price.

The power of the model lies in analysing how equilibrium changes when demand or supply shifts. Consider an increase in demand: the demand curve shifts right from D1 to D2, and at the old price there is now excess demand; this shortage bids the price up, which encourages an extension of supply (a movement along the supply curve) and a contraction of demand until a new equilibrium is reached at a higher price and higher quantity. Every applied question follows this discipline: identify which curve shifts and in which direction, describe the resulting excess demand or supply, and trace the adjustment to the new equilibrium price and quantity, referring to the diagram throughout ('price rises from P1 to P2 and quantity from Q1 to Q2').

The price mechanism performs three interlinked functions in allocating scarce resources, which are the heart of how a market economy answers the what, how and for whom questions. The rationing function: when a good becomes scarcer, its price rises, rationing the limited supply to those most willing and able to pay. The incentive function: a higher price is an incentive for producers to supply more (and, in the long run, to enter the market), and for consumers to economise. The signalling function: prices act as signals that transmit information to buyers and sellers about where resources should be allocated - a rising price signals to producers to move resources into that market, and a falling price signals to move them out.

The price mechanism is a remarkably efficient, decentralised way of coordinating the decisions of millions of independent agents without any central planner, and Adam Smith's 'invisible hand' captures the idea that self-interested behaviour can produce a socially efficient allocation. But this is an evaluation point, not an article of faith: the mechanism can fail. It ignores costs and benefits that fall on third parties (externalities), under-provides public goods, may distribute resources very unequally (only those able to pay are served), and can be distorted by market power - all of which are examined in the market-failure chapter. The equilibrium model is the essential benchmark against which those failures, and the case for government intervention, are judged.

An increase in demand raises equilibrium price and quantity

Fig. 5An increase in demand shifts D1 to D2; the resulting shortage bids price up from P1 to P2 and quantity rises from Q1 to Q2 as supply extends.

Worked example

Solving for equilibrium and tracing a shift

In a market, demand is P = 12 - Q and supply is P = 2 + Q. Find the equilibrium. Then demand rises so that it becomes P = 16 - Q. Find the new equilibrium and comment.

Set demand equal to supply
12 - Q = 2 + Q gives 10 = 2Q, so Q = 5, and P = 12 - 5 = 7. The initial equilibrium is P = 7, Q = 5.
Apply the demand increase
16 - Q = 2 + Q gives 14 = 2Q, so Q = 7, and P = 2 + 7 = 9. The new equilibrium is P = 9, Q = 7.
Interpret
The rightward shift of demand creates excess demand at the old price of 7; this bids price up to 9 and, as supply extends along the curve, quantity rises from 5 to 7.

Result: Equilibrium moves from (P = 7, Q = 5) to (P = 9, Q = 7): the increase in demand raises both price and quantity.

Typical mistakes

Shifting both curves at once when only one determinant has changed, or shifting the wrong curve.
Asserting that price 'just rises' without explaining the excess-demand/excess-supply adjustment that drives it.

Active revision

Using a demand and supply diagram, analyse the effect on the market for electric cars of a large government subsidy to producers combined with rising consumer concern about emissions.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

Consumer and producer surplus and interrelated markets#

AdvancedAQA 7136 4.1.3DfE GCE Economics - consumer and producer surplus

Consumer and producer surplus

Fig. 6Consumer surplus is the shaded area below demand and above the price; producer surplus is the shaded area above supply and below the price. Together they are total welfare.

Consumer surplus is the difference between the total amount consumers are willing and able to pay for a good and the total amount they actually pay - it is the benefit consumers gain from paying a market price lower than their maximum willingness to pay. On a diagram it is the area below the demand curve and above the market price, up to the equilibrium quantity. It arises directly from diminishing marginal utility: early units are worth far more to the consumer than the price paid, so the consumer 'gains' the gap. Producer surplus is the mirror image: the difference between the price producers actually receive and the minimum they would have been willing to accept (their marginal cost of supply), shown as the area above the supply curve and below the market price.

Together, consumer and producer surplus make up the total welfare (or economic welfare) generated by a market, and the equilibrium of a competitive market maximises this combined surplus - which is the formal sense in which a competitive market is allocatively efficient. This gives a powerful tool for evaluating any change: an event that raises the combined surplus improves welfare, while a tax, a monopoly restriction of output or another distortion that reduces it creates a welfare loss (deadweight loss). Shifts in demand and supply redistribute and resize these surpluses - for example, an increase in supply lowers price, raising consumer surplus, and the change in producer surplus depends on the elasticities.

Markets are interrelated, so a change in one market ripples into others, and the specification requires four relationships to be understood. Substitutes are goods in competing demand (a rise in the price of one raises demand for the other - butter and margarine). Complements are goods in joint demand (consumed together, so a rise in the price of one lowers demand for the other - cars and petrol). Derived demand is demand for a good that arises from demand for something else (the demand for labour and for steel is derived from the demand for the goods they help produce). And on the supply side, joint supply means two goods are produced together (beef and leather), while composite demand means a good is demanded for several competing uses (land for housing or farming).

These linkages matter because they extend the analysis beyond a single market and are frequently tested in data-response questions. A fall in the price of crude oil, for instance, lowers the cost of petrol (a complement to cars, raising car demand), reduces the cost of producing plastics (a shift in a supply curve elsewhere), and affects the demand for substitutes such as public transport. A strong answer identifies the relevant relationship, applies the correct demand or supply shift in the connected market, and traces the effect on that market's equilibrium price, quantity and surpluses - always evaluating that the SIZE of the effect depends on the closeness of the relationship (the cross elasticity) and on the elasticities of demand and supply.

\text{Consumer surplus} = \tfrac{1}{2} \times Q_e \times (P_{max} - P_e)

Consumer surplus (linear demand)

For a straight-line demand curve, consumer surplus is the area of the triangle between the demand curve and the equilibrium price up to the equilibrium quantity.

Worked example

Calculating consumer and producer surplus

In a market, demand is P = 12 - Q and supply is P = 2 + Q, giving equilibrium P = 7, Q = 5. Calculate the consumer surplus and the producer surplus.

Find the relevant intercepts
The demand curve meets the price axis at P = 12 (where Q = 0); the supply curve meets it at P = 2. The equilibrium price is 7 and quantity is 5.
Consumer surplus
It is the triangle between demand (top at 12) and the price (7), over quantity 0 to 5: CS = 0.5 x 5 x (12 - 7) = 0.5 x 5 x 5 = 12.50 pounds.
Producer surplus
It is the triangle between the price (7) and supply (bottom at 2), over quantity 0 to 5: PS = 0.5 x 5 x (7 - 2) = 0.5 x 5 x 5 = 12.50 pounds.

Result: Consumer surplus is 12.50 pounds and producer surplus is 12.50 pounds, giving total welfare of 25 pounds at the competitive equilibrium.

Typical mistakes

Reversing consumer and producer surplus on the diagram - consumer surplus is ABOVE the price line, producer surplus is BELOW it.
Confusing joint demand (complements, bought together) with composite demand (competing uses of one good).

Active revision

Using a diagram, explain what happens to consumer and producer surplus when an increase in supply lowers the equilibrium price of a good.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

References & sources

Sources

Department for Education

GCE AS and A level subject content for economics

AQA

AQA A-level Economics 7136 specification

Price determination in a competitive market

5 sections~23 min reading time4 competenciesLevel Foundation 1 · Standard 3 · Advanced 1

Price determination in a competitive market

Key points

Classifying determinants as shifts or movements

Key points

Calculating and interpreting PED and YED

Key points

Calculating PES and reasoning about the time period

Key points

Solving for equilibrium and tracing a shift

Key points

Calculating consumer and producer surplus

Sources

Price determination in a competitive market

Key points

Classifying determinants as shifts or movements

Key points

Calculating and interpreting PED and YED

Key points

Calculating PES and reasoning about the time period

Key points

Solving for equilibrium and tracing a shift

Key points

Calculating consumer and producer surplus

Sources