Price changes
To understand price changes, we must first define the market equilibrium. The equilibrium is the point where the quantity demanded by consumers equals the quantity supplied by producers. At this point, there is no shortage or surplus.
The market price and quantity are determined by the interaction of two forces:
- Demand: The willingness and ability of consumers to buy a good at various prices.
- Supply: The willingness and ability of producers to sell a good at various prices.
When external conditions change (e.g., income levels, technology, weather), either the demand curve or the supply curve shifts. This shift creates a new equilibrium with a different price (P) and quantity (Q).
Building on first principles:
- If Demand increases (shifts right): Consumers want more at every price. This creates a shortage at the old price, pushing prices up. As price rises, quantity supplied increases until a new equilibrium is reached.
- If Supply decreases (shifts left): Producers supply less at every price. This creates a shortage at the old price, pushing prices up. As price rises, quantity demanded falls until a new equilibrium is reached.
| Effect on Equilibrium Quantity ($Q$) |
|---|
| Increases (\uparrow) |
| Decreases (\downarrow) |
| Increases (\uparrow) |
| Decreases (\downarrow) |
Equilibrium Price (P_e): The price at which the quantity demanded equals the quantity supplied. At this price, the market clears.
Equilibrium Quantity (Q_e): The quantity of goods bought and sold at the equilibrium price.
Shift vs. Movement:
- A shift of the curve is caused by an external factor (determinant) other than the price of the good itself (e.g., change in income, technology).
- A movement along the curve is caused ONLY by a change in the price of the good itself.
Scenario: A severe drought affects coffee-growing regions.
Step 1: Identify the change.
The drought reduces the ability of farmers to produce coffee. This is a negative supply shock. The Supply curve shifts to the left (from S_1 to S_2).
Step 2: Determine the new equilibrium.
- The demand curve remains unchanged (assuming consumer preferences haven't changed).
- At the original price, there is now a shortage because supply < demand.
- This shortage pushes the price up.
- Result: The new equilibrium has a higher price (P_2 > P_1) and a lower quantity (Q_2 < Q_1).
Visualizing the Diagram:
- Draw axes: Vertical axis = Price (P), Horizontal axis = Quantity (Q).
- Draw downward-sloping Demand curve (D) and upward-sloping Supply curve (S_1). Mark initial equilibrium E_1.
- Draw a new Supply curve (S_2) to the left of S_1.
- Mark the new intersection with D as E_2.
- Show that P_2 is higher than P_1 and Q_2 is lower than Q_1.
The Correct Understanding:
- Change in Demand: Refers to a shift of the entire demand curve. This happens due to non-price factors (e.g., income, tastes, price of substitutes).
- Change in Quantity Demanded: Refers to a movement along the existing demand curve. This happens ONLY when the price of the good changes.
Why this matters: If you are asked to explain why the price of coffee rose due to a drought, you must state that supply decreased. You cannot say "demand increased" unless there is evidence that consumers suddenly wanted more coffee for reasons other than price.
The Context: Examiners award marks for specific visual elements. A diagram without labels is often worth zero marks.
Why examiners accept this: The markscheme requires precise identification of variables to prove you understand the model, not just the shape.
Correct Usage Example:
- Axes: Label the vertical axis 'Price' (or P) and the horizontal axis 'Quantity' (or Q). Do not label them 'Cost' or 'Amount'.
- Curves: Label the downward curve 'Demand' (D) and the upward curve 'Supply' (S).
- Shifts: If supply decreases, draw a new curve labeled S_1 (original) and S_2 (new). Use an arrow to show the direction of the shift.
- Equilibria: Mark the initial equilibrium as E_1 and the new one as E_2. Draw dashed lines from E_1 and E_2 to the axes to clearly indicate P_1, P_2, Q_1, Q_2. Define these variables in your text: 'P_1 is the initial price, P_2 is the new higher price.'
Note on Notation: While 'Price' and 'Quantity' are the axis labels, use P and Q in your explanation to refer to specific values. For example, 'The price rises from P_1 to P_2.'
Sales in this context refers to Total Revenue (TR) for the firm or market. Total Revenue is calculated as:
TR = P \times Q
where P is the price per unit and Q is the quantity sold.
When the price changes, two things happen simultaneously:
- The Price (P) changes.
- The Quantity (Q) demanded changes (due to the law of demand).
Whether Total Revenue increases or decreases depends on which effect is stronger. This sensitivity is known as Price Elasticity of Demand (PED), but we can understand it conceptually without complex formulas:
Case 1: Price Increases
- P goes up (good for revenue).
- Q goes down (bad for revenue).
- If consumers are not very sensitive to price (e.g., essential goods like medicine), the drop in Q is small. The gain from higher P outweighs the loss from lower Q. Total Revenue increases.
- If consumers are very sensitive to price (e.g., luxury goods or substitutes available), the drop in Q is large. The loss from lower Q outweighs the gain from higher P. Total Revenue decreases.
Case 2: Price Decreases
- P goes down (bad for revenue).
- Q goes up (good for revenue).
- If consumers are not very sensitive to price, the rise in Q is small. The loss from lower P outweighs the gain from higher Q. Total Revenue decreases.
- If consumers are very sensitive to price, the rise in Q is large. The gain from higher Q outweighs the loss from lower P. Total Revenue increases.
Summary for Novices:
- Price rises + Inelastic demand (insensitive buyers) = Revenue Up.
- Price rises + Elastic demand (sensitive buyers) = Revenue Down.
- Price falls + Inelastic demand = Revenue Down.
- Price falls + Elastic demand = Revenue Up.
A) An increase in demand
B) A decrease in demand
C) An increase in supply
D) A decrease in supply
D
Reasoning:
- We need a scenario where Price (P) increases and Quantity (Q) decreases.
- Look at the key concept table:
- Demand Increase: P \uparrow, Q \uparrow (Incorrect)
- Demand Decrease: P \downarrow, Q \downarrow (Incorrect)
- Supply Increase: P \downarrow, Q \uparrow (Incorrect)
- Supply Decrease: P \uparrow, Q \downarrow (Correct)
- Therefore, a decrease in supply causes the price to rise and quantity to fall.
- Axes: Vertical axis labeled 'Price' (P), Horizontal axis labeled 'Quantity' (Q).
- Curves: Downward-sloping Demand curve (D_1) and upward-sloping Supply curve (S). Label them clearly.
- Initial Equilibrium: Mark the intersection of D_1 and S as E_1. Draw dashed lines to axes for P_1 and Q_1.
- Shift: Since demand for swimming pools increases, the demand for water (a complementary good) also increases. Shift the Demand curve to the right from D_1 to D_2. Label the new curve D_2.
- New Equilibrium: Mark the intersection of D_2 and S as E_2. Draw dashed lines to axes for P_2 and Q_2.
Explanation:
The increase in demand shifts the demand curve to the right. This creates a shortage at the original price, pushing the price up. The new equilibrium is at a higher price (P_2 > P_1) and a higher quantity (Q_2 > Q_1).
Answer Structure:
House prices increase when there is an increase in demand or a decrease in supply.
Example of Demand Increase:
- Lower interest rates reduce the cost of borrowing mortgages.
- This increases consumers' ability to purchase houses (effective demand).
- The demand curve shifts to the right.
- At the original price, there is excess demand (shortage).
- Competition among buyers drives the price up until a new equilibrium is reached at a higher price and quantity.
Example of Supply Decrease:
- A shortage of building materials or labor reduces the ability to build new homes.
- The supply curve shifts to the left.
- At the original price, there is excess demand.
- Prices rise to clear the market.