The Price System and Government Intervention
The price system domain tests how markets allocate scarce resources and how governments alter that allocation. Exam questions typically ask you to explain the rationing, signalling and incentive functions of price, calculate and interpret elasticities, and evaluate taxes, subsidies, price controls and pollution permits.
Core rules and concepts
- The price mechanism performs three functions: rationing (a price rise reduces quantity demanded), signalling (price indicates where demand is greatest) and incentive (higher prices encourage firms to supply more).
- Equilibrium occurs where demand equals supply. A shift of demand or supply changes price and quantity; a change in price causes movement along a curve.
- PED = %ΔQd / %ΔP; PES = %ΔQs / %ΔP. Demand is more elastic when substitutes exist, the good takes a large share of income, or the time period is long.
- YED is positive for normal goods (greater than 1 for luxuries) and negative for inferior goods. XED is positive for substitutes and negative for complements.
- A specific tax shifts the supply curve up by the tax; an ad valorem tax pivots it. The burden falls more heavily on the side of the market that is more inelastic.
- A maximum price below equilibrium creates a shortage. A minimum price above equilibrium creates a surplus, often handled with buffer stocks, quotas or government purchases.
- Tradable permits cap total pollution and allow the permit price to allocate abatement between firms.
Worked example
Demand is Qd = 100 − 2P and supply is Qs = 20 + 2P. Equilibrium: 100 − 2P = 20 + 2P, so P = 20 and Q = 60. A maximum price of 15 gives Qd = 70 and Qs = 50, a shortage of 20 units. Instead, a specific tax of 6 makes supply Qs = 20 + 2(P − 6) = 8 + 2P. New equilibrium: 100 − 2P = 8 + 2P, so P = 23 and Q = 54. Consumers pay 23 and producers keep 17, so the tax is shared equally because the demand and supply slopes have equal magnitude. Tax revenue is 6 × 54 = 324.
Traps that cost marks
- Saying a price ceiling causes a surplus, or failing to calculate the shortage.
- Confusing a shift of a curve with movement along it.
- Calculating tax revenue using the old quantity rather than the new quantity.
- Assuming legal incidence equals economic incidence.
- Treating a buffer stock as costless: storage, finance and disposal all matter.