Price Determination (Edexcel A Level Economics A)

Revision Note

Steve Vorster

Written by: Steve Vorster

Reviewed by: Jenna Quinn

Price Determination & Equilibrium

Price determination

  • In a free market economy, prices are determined by the interaction of demand and supply in a market

    • A market is any place that brings buyers and sellers together

    • Markets can be physical (e.g. Waterstones) or virtual (e.g. eBay)

  • Buyers and sellers meet to trade at an agreed price

    • Buyers agree the price by purchasing the good/service

    • If they do not agree on the price then they do not purchase the good/service and are exercising their consumer sovereignty

  • Based on this interaction with buyers, sellers will gradually adjust their prices until there is an equilibrium price and quantity that works for both parties

    • At the equilibrium price, sellers will be satisfied with the rate/quantity of sales

    • At the equilibrium price, the utility/price combination is maximised for the buyers

Equilibrium

  • Equilibrium in a market occurs when demand = supply

  • At this point the price is called the market clearing price

    • This is the price at which sellers are clearing their stock at an acceptable rate

1-2-6-market-equilibrium_edexcel-al-economics
A graph showing a market in equilibrium with a market clearing price at P and quantity at Q
  • Any price above or below P creates disequilibrium in this market

    • Disequilibrium occurs whenever there is excess demand or supply in a market

Market Disequilibrium

Disequilibrium - excess demand

  • Excess demand occurs when the demand is greater than the supply

    • It can occur when prices are too low or when demand is so high that supply cannot keep up with it

1-2-6-excess-demand_edexcel-al-economics
A graph that depicts the condition of excess demand in the market for electric scooters

Diagram analysis

  • At a price of P1, the quantity demanded of electric scooters (Qd) is greater than the quantity supplied (Qs)

  • There is a shortage in the market equivalent to QsQd

Market response

  • This market is in disequilibrium

    • Sellers are frustrated that products are selling so quickly at a price that is obviously too low

    • Some buyers are frustrated as they will not be able to purchase the product

  • Sellers realise they can increase prices and generate more revenue and profits

  • Sellers gradually raise prices

    • This causes a contraction in QD as some buyers no longer desire the good/service at a higher price

    • This causes an extension in QS as sellers are more incentivised to supply at higher prices

  • In time, the market will have cleared the excess demand and arrive at a position of equilibrium (PeQe)

    • Different markets take different lengths of time to resolve disequilibrium. For example, retail clothing can do so in a few days. Whereas the housing market may take several months

Disequilibrium - excess supply

  • Excess supply occurs when the supply is greater than the demand

    • It can occur when prices are too high or when demand falls unexpectedly 

  • During the later stages of the pandemic the market for face masks was in disequilibrium

1-2-6-excess-supply_edexcel-al-economics
A graph that depicts the condition of excess supply in the market for Covid-19 face masks during the later stages of the pandemic

Diagram analysis

  • At a price of P1, the quantity supplied of face masks (Qs) is greater than the quantity demanded (Qd)

  • There is a surplus in the market equivalent to QdQs

Market response

  • This market is in disequilibrium

    • Sellers are frustrated that the masks are not selling and that the price is obviously too high

    • Some buyers are frustrated as they want to purchase the masks but are not willing to pay the high price

  • Sellers will gradually lower prices in order to generate more revenue

    • This causes a contraction in QS as some sellers no longer desire to supply masks

    • This causes an extension in QD as buyers are more willing to purchase masks at lower prices

  • In time, the market will have cleared the excess supply and arrive at a position of equilibrium (PeQe)

Use of Diagrams to Show Market Changes

  • Real world markets are constantly changing and are referred to as dynamic markets

  • Market equilibrium can change every few minutes in some markets (e.g. stocks and shares), or every few weeks or months in others (e.g. clothing)

  •  Any change to a condition of demand or supply will temporarily create disequilibrium and market forces will then seek to clear the excess demand or supply

Real world example: changes to demand that increase price

  • During lock downs associated with the Covid-19 pandemic, furniture retailers experienced unexpectedly high demand for their products (especially desks and sofas)

1-2-6-increase-in-demand_edexcel-al-economics
Diagram showing an increase in demand for desks due to a temporary change in tastes/fashions

Diagram analysis

  • Due to the Covid mandated change of working from home, consumers experienced a temporary change in taste as they sought to set up comfortable home offices

    • This led to an increase in demand for desks from D1→D2

  • At the original market clearing price of P1, a condition of excess demand now exists

    • The demand for desks is greater than the supply

  • In response, suppliers raise prices

    • This causes a contraction of demand and an extension of supply, leading to a new market equilibrium at P2Q2

    • Both the equilibrium price (P2) and the equilibrium quantity (Q2) are higher than before

    • The excess demand in the market has been cleared

Real world example: changes to supply that increase price

  • Ukraine is one of the world's largest producers of wheat. During the Russian-Ukrainian war, exports of wheat have been halted

  • India imported 13% of the nation's wheat requirements from Ukraine

1-2-6-decrease-in-supply_edexcel-al-economics
Diagram showing an decrease in supply of wheat in India due to a supply shock caused by the war in Ukraine

Diagram analysis

  • Due to the war in Ukraine, India is experiencing a supply shock in its wheat market

    • This causes a decrease in supply of S1→S2

  • At the original market clearing price of P1, a condition of excess demand now exists (shortage)

    • The demand for wheat is greater than the supply

  • In response, sellers in India raise prices

    • This causes a contraction of demand and an extension of supply, leading to a new market equilibrium at P2Q2

    • The equilibrium price (P2) is higher and the equilibrium quantity (Q2) is lower than before

    • The excess demand in the market has been cleared

Real world example: changes to demand that decrease price

  • Demand for lobsters in Maine, USA has been falling steadily in recent months

  • This has resulted in a price fall from $12.35 /pound on the 1st April to $9.35 /pound on the 1st May

1-2-6-decrease-in-demand_edexcel-al-economics
Diagram showing a decrease in demand for lobsters due to a decrease in real income

Diagram analysis

  • In recent months, the USA has been experiencing an increasing rate of inflation

    • Inflation lowers the purchasing power of money in a consumer's pocket and so effectively reduces their real income

    • With reduced real income, fewer luxuries are consumed

    • This led to a decrease in demand for lobsters from D1→D2

  • At the original market clearing price of P1, a condition of excess supply now exists

    • The demand for lobsters is less than the supply

  • In response, suppliers gradually reduce prices

    • This causes a contraction of supply and an extension of demand leading to a new market equilibrium in P2Q2

    • Both the equilibrium price (P2) and the equilibrium quantity (Q2) are lower than before

    • The excess supply in the market has been cleared

Real world example: changes to supply that decrease price

  • In order to help meet their climate targets and to lower energy costs for households, the EU is providing subsidies for solar panels 

1-2-6-increase-in-supply_edexcel-al-economics
Diagram showing an increase in supply of solar panels in the EU due to a per unit subsidy

Diagram analysis

  • To help meet its climate change targets and lower household energy bills the EU has provided subsidies to solar panel retailers

    • This causes an increase in supply of S1→S2

  • At the original market clearing price of P1, a condition of excess supply now exists (surplus)

    • The supply of solar panels is greater than the demand

  • In response, sellers in the EU lower prices

    • This causes an extension of demand and a contraction of supply, leading to a new market equilibrium at P2Q2

    • The equilibrium price (P2) is lower and the equilibrium quantity (Q2) is higher than before

    • The excess supply in the market has been cleared

Examiner Tips and Tricks

MCQ, short answer and essay questions frequently require you to explain dynamic changes in markets. Explaining the steps in the change is often referred to as chains of analysis or reasoning, and students frequently leave out some steps in the chain.

Step 1: From the scenario, identify if the change in condition is on the demand side or supply side.

Step2: State which way the demand or supply curve moves and use annotation, e.g. S1→S2.

Step 3: State the disequilibrium that now exists at the original market price.

Step 4: State if sellers raise or lower prices to clear the disequilibrium.

Step 5: Explain the relevant contraction and extension in quantity that occurs on the demand and supply curves due to the change in price.

Step 6: State the new market equilibrium points e.g. P2Q2.

Step 7: Explain the market outcome (is the new price/quantity higher/lower than the original?)

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Steve Vorster

Author: Steve Vorster

Expertise: Economics & Business Subject Lead

Steve has taught A Level, GCSE, IGCSE Business and Economics - as well as IBDP Economics and Business Management. He is an IBDP Examiner and IGCSE textbook author. His students regularly achieve 90-100% in their final exams. Steve has been the Assistant Head of Sixth Form for a school in Devon, and Head of Economics at the world's largest International school in Singapore. He loves to create resources which speed up student learning and are easily accessible by all.

Jenna Quinn

Author: Jenna Quinn

Expertise: Head of New Subjects

Jenna studied at Cardiff University before training to become a science teacher at the University of Bath specialising in Biology (although she loves teaching all three sciences at GCSE level!). Teaching is her passion, and with 10 years experience teaching across a wide range of specifications – from GCSE and A Level Biology in the UK to IGCSE and IB Biology internationally – she knows what is required to pass those Biology exams.