Price Mechanism – Demand & Supply: Key Exam Notes

Learning Objectives

• Explain how the price mechanism allocates scarce resources via signalling, incentive & rationing.
• Distinguish movements along vs shifts of demand & supply.
• Predict effects of changes in demand and/or supply on equilibrium $P$ & $Q$.
• Define & compute consumer surplus (CS) and producer surplus (PS).
• Apply demand–supply logic to factor markets (e.g.a labour).

Price Mechanism: Core Functions

• Signalling – price changes convey information about relative scarcity.
• Incentive – higher $P$ rewards producers to expand output; lower $P$ encourages consumption.
• Rationing – scarce goods go to buyers most willing & able to pay.

Demand

• Effective demand: quantity consumers willing & able to buy at each $P$, ceteris paribus (cp).
• Law of Demand: inverse $P$–$Q_d$ relationship.
• Individual demand derived from diminishing marginal utility (set $MU = P$).
• Market demand: horizontal sum of individual curves.
• Movement along curve: caused by own-price change → change in $Q_d$.
• Six key non-price shifters ("PTYDE + O"):
  • $P_{rg}$ Substitutes (↑ substitute price ⇒ $D$↑) & Complements (↑ complement price ⇒ $D$↓)
  • Tastes & preferences
  • Income (↑ income ⇒ $D$↑ for normal, $D$↓ for inferior)
  • Demographics
  • Expectations of future price/income
  • Others (govt rules, interest rate, weather, exchange rate)

Supply

• Effective supply: quantity firms willing & able to sell at each $P$, cp.
• Law of Supply: direct $P$–$Q_s$ relationship.
• Individual supply derived from rising marginal cost (set $MC = P$).
• Market supply: horizontal sum of individual curves.
• Movement along curve: own-price change → change in $Q_s$.
• Five key non-price shifters ("CPSS E"):
  • Cost of production (tech, taxes/subsidies, input costs)
  • $P<em>{rg}$ Joint supply (↑ price of X ⇒ $S</em>Y$↑) & Competitive supply (↑ price of X ⇒ $S_Y$↓)
  • Sellers (number of firms)
  • Supply shocks (weather, disasters)
  • Expectations of future price

Market Equilibrium

• Occurs where $Q<em>d = Q</em>s$ at $(P<em>e, Q</em>e)$ → no tendency for change.
• Surplus ($Q<em>s > Q</em>d$): downward pressure on $P$ until equilibrium restored.
• Shortage ($Q<em>d > Q</em>s$): upward pressure on $P$ until equilibrium restored.

Simultaneous Shifts (Quick Guide)

• Both $D$ & $S$ ↑ ⇒ $Q<em>e$ ↑; impact on $P</em>e$ indeterminate.
• Both $D$ & $S$ ↓ ⇒ $Q<em>e$ ↓; $P</em>e$ indeterminate.
• $D$ ↑, $S$ ↓ ⇒ $P<em>e$ ↑; $Q</em>e$ indeterminate.
• $D$ ↓, $S$ ↑ ⇒ $P<em>e$ ↓; $Q</em>e$ indeterminate.
• Magnitude of shifts determines actual $P<em>e, Q</em>e$ outcome.

Consumer & Producer Surplus

• Consumer surplus: area below demand & above $P_e$.
• Producer surplus: area above supply & below $P_e$.
• $\text{Total Surplus}= CS + PS$ → measures social welfare; maximised at market equilibrium (allocative efficiency).

Factor Market Example: Labour

• Price of labour = wage ($W$).
• Demand for labour (firms): downward sloping; shifts right when
  • Product demand ↑, labour productivity ↑, or price of capital (substitute) ↑.
• Supply of labour (households): upward sloping; shifts right when
  • Working population ↑, non-monetary job benefits ↑, or alternative wages ↓.
• Intersection gives $W<em>e$ and equilibrium employment $L</em>e$.

Efficiency Summary

• "What & for whom": shifts in $D$ signal producers; higher $P$ rations output to paying consumers.
• "How": competition forces firms to adopt least-cost techniques (productive efficiency).
• In a free market with no failures, price mechanism maximises total surplus → allocative & productive efficiency.

Exam Tip: Price Adjustment Narrative

1. State initial equilibrium $E<em>0 (P</em>0, Q_0)$.
2. Identify surplus/shortage at old price after shift.
3. Explain price movement and corresponding movements along curves.
4. Conclude with new equilibrium $E<em>1 (P</em>1, Q_1)$ and direction of change.