The Price System: Demand, Supply, Elasticity and Market Equilibrium
Domain 2 tests whether you shift curves for the right reason and use elasticity numerically - in tax incidence, pricing and revenue decisions - rather than quoting definitions.
Core rules
- A movement along a curve is caused by price; a shift is caused by a non-price determinant. Demand shifters: income, tastes, prices of substitutes and complements, expectations, number of buyers. Supply shifters: input costs, technology, indirect taxes and subsidies, weather, number of firms.
- Equilibrium is where quantity demanded equals quantity supplied. A shortage pushes price up; a surplus pushes it down.
- PED = %Δ quantity demanded ÷ %Δ price; it is negative, and demand is elastic when |PED| > 1. Determinants: substitute availability, proportion of income, necessity, time horizon.
- PES rises with time, spare capacity and stock levels.
- An indirect tax shifts supply up; the burden falls more heavily on whichever side of the market is less elastic.
- A maximum price creates a shortage (queues, rationing, black markets); a minimum price creates a surplus requiring a buffer stock or quota.
Worked example
A firm faces PED of 2 (absolute value) and raises price 5%. Quantity demanded falls 10%, so new revenue = 1.05P × 0.90Q = 0.945PQ: revenue falls about 5.5%. Raising price only adds revenue when demand is inelastic (|PED| < 1).
Traps
Writing "demand falls" when quantity demanded falls; showing a tax as a demand shift; comparing PED values while ignoring the negative sign; forgetting that XED is positive for substitutes and negative for complements.