2

2 How markets work

The operation of markets, market

failure and the role of government
2.1
1.1 The
Thedemand
demandfor
forgoods
goodsand
andservices
services
This section will develop your knowledge and understanding of:

➔ factors which determine the demand for a good or service
➔ how a demand curve shows the relationship between price and quantity demanded
➔ causes of shifts in the demand curve.
What determines the price of a good or service? Why is the price of

Link gold higher than the price of bananas? In free markets, the price of a
Free markets are explained in 1.3 good is determined by demand and supply.
“Scarcity, choice and the allocation
of resources”. Demand
Demand is the quantity that consumers are willing and able to buy
at a given price in a given period of time. It is not the same as a want.
Whatever people have, they are likely to want more. In Economics,
Key term demand means effective demand. The want has to be supported by the
Demand: the quantity that ability and willingness to pay for the good.
consumers are willing and able In Economics, the market demand is the total amount that all the
to buy at a given price in a given individual consumers of a product are willing and able to buy at a
period of time. given price in a period of time.
Factors which determine the demand for a good

Quantitative skills or service
When drawing diagrams in The price of the good or service
Economics which involve quantity As a rule, the higher the price, the lower the quantity demanded
and price, the quantity is always and the lower the price, the higher the quantity demanded. As price
put on the horizontal axis and the increases, consumers cannot afford to buy as much and may also buy
price on the vertical axis. alternative products which are now relatively cheaper.
This inverse relationship between price and quantity demanded
(where price and quantity demanded move in opposite directions) is
shown in the diagrams below, Figures 2.1.1 and 2.1.2.
Activities
Identify a product that you buy
often. Ask four friends or members
Price Price
of your family how much they (P) (P)
would be willing to buy of this
product at five different prices in a
given time and put your answers in Contraction Extension
p2 of demand p3 of demand
a table or spreadsheet.
p1 p4
1 Calculate the market demand
at each price.
Demand (D) Demand (D)
2 Draw a demand curve showing
how much would be bought at O q2 q1 Quantity O q3 q4 Quantity
each price. (Q) (Q)
3 What do you notice? ▲ Figure 2.1.1: A contraction of ▲ Figure 2.1.2: An extension of

demand demand
22
The demand for goods and services
A demand curve shows the relationship between price and quantity

demanded in a given time period. A point on the curve shows the
quantity consumers are willing and able to buy at that particular
price. If the price of the good or service changes, this is shown as a
movement along the demand curve. In Figure 2.1.1, as price rises from
p1 to p2, the quantity demanded falls from q1 to q2. This movement
back along the demand curve, showing a lower quantity demanded, is
called a contraction of demand.
In Figure 2.1.2, if price falls from p3 to p4, the quantity demanded rises
from q3 to q4. This movement along the curve because of a fall in price
is called an extension of demand.
Conditions of demand
Factors which determine the demand for a good, other than the price
of the good, are known as the conditions of demand. These include:
• income
• wealth
• the price of related goods and services
• individual preferences
• population.
Income
Income is a flow of money, received by an economic agent (such as
Key terms
an individual, firm or the country as a whole), over a period of time. Income: a flow of money, received
Generally, the higher the income, the higher the demand. These by an economic agent over a period
products are known as normal goods, for example new shoes. This of time.
is because more can be bought with a higher income. There may also
be products where demand falls as income rises, known as inferior Normal good: a product where
goods. demand increases if income rises.
This does not mean that inferior goods are of low quality, but they Inferior good: a product where
are often cheaper alternatives which are more likely to be bought by demand decreases if income rises.
people on low incomes. For example, a supermarket’s own brand of
Wealth: a stock of assets owned
tea may be cheaper than that of a well-known manufacturer. If their
by an economic agent at a point in
incomes rise, these consumers may then switch to what they believe
time.
to be better products.
Substitute goods or goods in
Wealth competitive demand: alternative
Wealth is a stock of assets owned by an economic agent at a point in products – if the price of one good
time. If people own assets, such as money in the bank or property, increases, so will demand for the
they are able to buy more. This will increase demand. The opposite other. They are in competitive
applies if wealth falls.
demand.
The price of related goods and services
The price of substitutes
Substitute goods are alternative products – if the price of one good
increases, so will demand for the other. These are also known as
goods in competitive demand. Similarly, if the price of one good
falls, so will demand for the other. For example, in many countries,
tea and coffee are alternative drinks. If the price of coffee rises, fewer
people will buy coffee and this will increase the demand for tea.
23
2 How markets work
The price of complementary goods

Key terms Complementary goods are products that are bought or used
Complementary goods or goods together – if the demand for one good increases, so will demand
in joint demand: products that are for the other. These are also known as goods in joint demand.
bought or used together – if the Similarly, if the demand for one good falls, demand for the other
demand for one good increases, will also fall. For example, if the price of cars rises, fewer people
so will demand for the other. They will be able to afford to buy cars and this will also reduce the
are in joint demand. demand for fuel.
Other things being equal (ceteris Individual preferences

paribus): the assumption that Everyone is different and so is the combination of goods and services
nothing else changes. they buy. This is sometimes called their pattern of demand. People’s
preferences may be influenced by a number of factors:
Link Advertising
Speculation, another factor Advertising aims to inform consumers and to persuade them to buy
some products instead of others, perhaps to buy a different make of
affecting the demand for some
car. Successful advertising will therefore increase demand for one
products, will be covered in 2.5 “The
product and may reduce it for others. Products may also go in and out
determination of market prices”.
of fashion.
Social and emotional factors

We traditionally assume that consumers act rationally, considering
the satisfaction they will gain from a product (sometimes called utility
in Economics) in relation to its price. However, this is not always
the case.
Behavioural economics suggests that we are influenced by a variety of
social and emotional factors and do not always act rationally. Products
may be bought on impulse or we may be influenced by what our
friends do.
Population
The more people that live in a country, the greater the demand for
a product is likely to be. For example, China and India would be
expected to have a higher demand for a particular product, other
things being equal, than smaller countries such as Malaysia and
Singapore.
The expression “other things being equal” is a common assumption
in Economics and is sometimes written in its Latin form, ceteris
paribus.
Movements along a demand curve and shifts in

the demand curve
Movements along the demand curve
As said previously, if the price of a product changes, this causes a
movement along the demand curve because the demand curve shows
how much will be demanded at different prices. If there is a change in
any other factor that influences the demand for a product, except for
its price, then there is a shift of the demand curve.
24
The demand for goods and services
Shifts of the demand curve

If there is a change in income, wealth, the price of related goods and
services, individual preferences, population or any other non-price
factor that could affect the demand for a product, then the whole
demand curve will shift.
A shift to the right shows an increase in demand, where at each and
every price more is demanded than before. Similarly, a shift to the
left shows a decrease in demand, where less is demanded at each and
every price.
P P
p1
p2
Progress questions
D1 D2
D4 D3 1 What causes a movement
O q1 q2 Q O q4 q3 Q along the demand curve as
opposed to a shift of the
▲ Figure 2.1.3: An increase in demand ▲ Figure 2.1.4: A decrease in demand
demand curve?
For example, in Figure 2.1.3, after the demand curve for mobile 2 What is another term for
phones has shifted from D1 to D2, at price p1, demand has increased complementary goods?
from q1 to q2. This may be because of a rise in incomes. 3 Will an increase in income
shift the demand curve for an
Similarly, in Figure 2.1.4, after the demand curve for bananas has
inferior good to the left or the
shifted from D3 to D4, at price p2, demand has fallen from q3 to q4.
right?
This may be because of a fall in the price of pineapples.
Case study: Changes in China’s automotive market

China is the world’s biggest automotive market. In 2015,
there were around 21 million sales. It is also the largest
carbon emitter in the world with 10% of its greenhouse gas
emissions coming from transport. This is partly because of
its large population.
There is growing concern in many countries about the
amount of pollution caused by fossil fuels such as oil.
Therefore, the Chinese government is encouraging the
use of green energy, including for vehicles. Although
only a small part of the market, sales are increasing for
vehicles using these fuels. By 2025, one in every five
cars sold in China must use alternative fuels, such as
electricity.
1 What is the economic term used to describe the
relationship between fossil fuels and electricity in this ▲ Figure 2.1.5: Inside a modern car factory
example? 2 Draw a diagram to show the change in demand for oil if
more consumers buy vehicles that use electricity.
25
2.2 Price, income and cross elasticities of demand

➔ the meaning of price, income and cross elasticity of demand
➔ the relationship between income elasticity of demand and normal and inferior goods
➔ the relationship between cross elasticity of demand and substitute and complementary
goods
➔ the relationship between price elasticity of demand and firms’ total revenue (total
expenditure)
➔ factors that influence these elasticities of demand.
Demand is affected by many factors. These include the price of the

good, income and the price of other goods. Price, income and cross
elasticities of demand measure the extent of changes in demand
following changes in the price of that good, changes in income or
changes in the price of another good.
Elasticities of demand
Elasticity is a measure of how much one variable changes in response
to a change in another. There are three elasticities of demand.
• Price elasticity of demand
• Income elasticity of demand
• Cross elasticity of demand
Price elasticity of demand

As well as knowing that a change in price will cause a change in the
quantity demanded, it is often useful to know how much the demand
will change relative to the change in price. Will it change by a larger
or smaller percentage? Price elasticity of demand (PED) provides a
numerical value using these percentage changes:
PED = percentage change in quantity demanded
percentage change in price
Using the Greek letter delta (Δ) for change and accepted abbreviations,
this can be shortened to:
PED = % Δ in QD
% Δ in P
Price elasticity of demand is a measure of the percentage change in
quantity demanded as a result of a given percentage change in price,
Key term or simply, the responsiveness of quantity demanded to a change in
Price elasticity of demand: a price.
measure of the percentage change
In most situations, a rise in price will reduce the quantity demanded
in quantity demanded as a result of
and a fall in price will increase the quantity demanded.
a given percentage change in price,
or simply, the responsiveness of
Elastic and inelastic demand
quantity demanded to a change in
Since price and quantity demanded change in opposite directions, this
price.
means that PED will be negative.
26
Price, income and cross elasticities of demand
If the percentage change in price is less than the percentage change

in quantity demanded, demand is said to be elastic. If the percentage Get it right
change in price is greater than the percentage change in quantity You should not refer to a good as an
demanded, demand is inelastic. elastic or inelastic good. The good
The concept of elasticity is used ideally for small changes but in the is not elastic or inelastic. It is the
real world, changes may be quite large. demand (or supply) for the good
that is elastic or inelastic.
Example
In the diagram to the right (Figure 2.2.1), price has risen from $8 to P ($)
$10. As a result, the quantity demanded has fallen from 50 to 25 units.
10
B
1. What is the value of PED? 8
2. Is demand for the product elastic or inelastic? D
6
Answers:
4 C A
1. The percentage rise in price is 25% (+25) and the percentage fall in
2
quantity demanded is 50% (–50).
PED = –50 = –2 O 25 50 Q
+25
2. The percentage change in quantity demanded is greater than the ▲ Figure 2.2.1: Calculating PED
percentage change in price, so demand is elastic.
Ignoring the minus sign, if demand is elastic, PED will be a number
greater than 1, since the number on the top of the equation will be Quantitative skills
bigger than the number on the bottom. Elasticity has no units. Percentage changes are commonly
The graph below (Figure 2.2.2) and the following calculation show used in Economics. Make sure
inelastic demand: you have a method that works.
The difference between the new
If price falls from $10 to $2, quantity demanded rises from 40 to and the old figures should be
44 units. Here the percentage change in quantity demanded (+10%) is divided by the old/original figure
less than the percentage change in price (–80%), so demand is inelastic.
before multiplying by 100. If there
PED = +10 = –0.125 is a decrease, state this or use
–80
Ignoring the minus sign, if demand is inelastic, PED will be a number a minus sign. Do not forget to
less than 1, since the number on the top of the equation is smaller include the percentage sign. Use a
than the number on the bottom. calculator if helpful and check your
calculations carefully.
For a downward-sloping straight-line demand curve, PED becomes
less elastic as price falls. However, in the real world, demand curves
are unlikely to be straight lines.
P ($)
Link 10
The changing PED of a downward-sloping straight-line demand curve will be 8
discussed further in the A2 part of the course.
6 E
Activities 4
2
Draw a straight-line demand curve starting at $10 on the price axis and ending G
F D
at 10 units on the quantity axis.
O 10 20 30 40 44 Q
1 Calculate PED when price falls from $8 to $7. ▲ Figure 2.2.2: Inelastic demand
2 Calculate PED when price falls from $2 to $1.
3 What happens to PED as price falls?
27
2 How markets work
Perfectly elastic, perfectly inelastic and unit elasticity

There are also three extreme categories of PED, shown below:
P P
D
O Q O Q
▲ Figure 2.2.3: Perfectly elastic ▲ Figure 2.2.4: Perfectly inelastic
O Q
▲ Figure 2.2.5: Unit elasticity
If demand is perfectly elastic, there could be any demand at a

Link particular price but none at a higher price. The percentage change in
A firm in perfect competition has price is zero, giving a value for PED of infinity (∞).
a perfectly elastic demand curve. If demand is perfectly inelastic, demand stays the same at all prices.
This is covered in the A2 part of the The percentage change in demand is zero, giving a value for PED of
course. zero. This could happen for an individual’s demand for a product over
a narrow range of prices.
If demand is of unit elasticity, the percentage change in demand is the
same as the percentage change in price and since one of these will
increase and the other will decrease, the value of PED will be –1. For
example, a 10% rise in price causes a 10% fall in demand. This could
happen on rare occasions.
Key term Relationships between price elasticity of demand

and firms’ total revenue (expenditure)
Total revenue: income from sales,
Multiplying the price by the quantity sold gives the income from
calculated as price × quantity sold.
sales or total revenue of the firm. It is also the total expenditure
(spending) of the consumers.
28
What will happen to total revenue if demand is elastic?

If PED is elastic, the percentage change in demand is greater than the
percentage change in price.
For example, in Figure 2.2.1, when price rose by 25%, demand fell by
50%. The rise in price was more than offset by the fall in the quantity
sold. At the original price of $8, the total revenue/expenditure was
$400 ($8 × 50 units) but when price rose to $10, total revenue fell to
$250 ($10 × 25 units).
Before the price rise, total revenue is A + C. After the price rise, total
revenue falls to B + C. The revenue lost from area A is bigger than the
revenue gained from area B.
Had the price fallen from $10 to $8, total revenue would have risen
from $250 to $400.
Therefore, when demand is elastic, changes in price and total revenue
move in opposite directions.
What will happen to total revenue if demand is inelastic?

If PED is inelastic, the percentage change in demand is less than the
percentage change in price. For example, in Figure 2.2.2, when price
fell by 80%, demand only rose by 10%. The rise in quantity sold was
not enough to offset the fall in price.
At the original price of $10, the total revenue was $400 but when
price fell to $2, total revenue fell to $88.
Before the price fall, total revenue is E + G. After the price fall, total
revenue falls to F + G. The revenue gained from area F is smaller than
the revenue lost from area E.
Had the price risen from $2 to $10, total revenue would have risen
from $88 to $400.
Therefore, when demand is inelastic, changes in price and total
revenue move in the same direction.
What if demand is perfectly elastic, perfectly inelastic or of

unit elasticity?
If demand is perfectly elastic, there is no demand at a higher price. If
price rises, total revenue falls to zero.
If demand is perfectly inelastic, demand stays the same at all prices.
If price increases by 10%, total revenue will rise by 10%. If price
falls by 20%, total revenue falls by 20%. Therefore, the percentage
change in total revenue will be the same as the percentage change
in price.
If demand is of unit elasticity, the percentage change in demand is the
same as the percentage change in price. For any change in price, total
revenue will stay the same.
29
2 How markets work
▼ Table 2.2.1: Summary table for PED

Category Relationship Value What happens
between % to total revenue
changes in P and when price rises
QD
Perfectly elastic QD falls to zero PED = ∞ Falls to zero
after any rise in P
Elastic % change in QD > PED < –1 Falls
% change in P
Unit elasticity % change in QD = PED = –1 Stays the same
% change in P
Inelastic % change in QD < –1 < PED < 0 Rises
% change in P
Perfectly inelastic No change in QD PED = 0 Rises by the same
after any change percentage as
in P price
Factors that influence PED

Whether PED is elastic or inelastic depends on how much demand
changes in response to a change in price. This depends on, for
example:
• substitutes
• width of market
• time
• percentage of income spent on the product.
Substitutes
The most important factor influencing whether demand for a product
is elastic or inelastic is the availability of substitutes in that price range.
If there are similar products that could be bought, demand will usually
be elastic. It will be responsive to changes in price.
For example, if the price of one brand of TV increases, there is likely
to be a greater percentage fall in demand (than the percentage rise in
price) as people buy other brands of TV instead.
There may be some people who buy a Sony TV because they believe
them to be more reliable and of better quality than other TVs. This
may be because they owned Sony TVs before. They may buy a
particular brand of a product through habit. Their demand will be
inelastic but overall, demand for one brand is likely to be elastic.
If the price of petrol rises, there is likely to be a smaller percentage
fall in demand as those people with vehicles that use petrol have little
alternative (at least in the short run) than to continue to buy petrol.
Width of market
The example of TVs can be used to explain another factor influencing
PED. Generally, the wider the definition of the market, the less elastic
the demand for the product.
30
The market for Sony TVs will be smaller than the market for TVs as a
whole. If the price of Sony TVs changes, demand is likely to be more
responsive than if the price of all TVs increases. This is also because there
are more substitutes available for Sony TVs than for TVs as a whole.
Time
The example of petrol can be used to explain a further factor
influencing PED. Usually, the longer the time period, the more elastic
the demand for a product.
In the short run, people who have a car that uses petrol cannot easily
reduce the amount of petrol they buy if the price of petrol increases.
If the price of petrol remains high for a long time compared with other
fuels, such as electricity, then in the long run they may buy a car that
uses a different fuel. There are substitute fuels available but not for
the vehicle they have and it is not worthwhile changing straight away.
Percentage of income spent on the product

When the price of a good or service changes, this may be a small or
large percentage of a person’s income. Even if the price increases by
50%, if this is a very small percentage of a person’s income, they may
not believe that it is worth looking for a substitute. Their demand for
the product is likely to be inelastic.
If a large percentage of income is spent on the product, such as a car,
demand may be more elastic. Changes in price will be more significant
and have more effect on demand.
Necessities and luxuries?

Sometimes, it is said that the demand for necessities is inelastic and
that the demand for luxuries is elastic. This is based on the fact that
people cannot survive without necessities but do not need luxuries.
This cannot be treated as a general rule. For example, the demand for
fruit is relatively inelastic but the demand for melons may be elastic.
This is because there are substitutes for melons which people may buy
instead if the price of melons rises.
Case study: The price of postcards

Birdwing is a small firm in Sri Lanka making postcards. The
price it pays for raw materials has increased. The firm is
considering raising the price of a postcard from 100 to
120 Sri Lankan Rupees (LKR). It estimates that this
will reduce its demand for postcards per week from
1000 to 900.
1 Use the information above to calculate the PED for
postcards if the price increases from 100 to 120 LKR.
2 Calculate the expected change in total revenue.
3 Is demand in this price range elastic or inelastic?
Explain your answer.
▲ Figure 2.2.6: A beach in Sri Lanka
31
2 How markets work
Progress questions
1 Is PED positive or negative and why?
2 If demand is elastic and price rises, does total revenue fall, rise or stay the
same? Explain why.
3 If PED is −3 and the change in price is a fall of 5%, what is the percentage
change in quantity demanded?
Income elasticity of demand

It is also useful to know how much demand for a product will change
if people’s incomes change.
Income elasticity of demand (YED) is a measure of the percentage
Key term change in quantity demanded as a result of a given percentage change
Income elasticity of demand: in income, or simply, the responsiveness of quantity demanded to a
a measure of the percentage change in income.
change in quantity demanded The following formula is used to calculate income elasticity of demand:
as a result of a given percentage
change in income, or simply, Income elasticity of demand = percentage change in quantity demanded
percentage change in income
the responsiveness of quantity Using accepted abbreviations, this can be shortened to:
demanded to a change in income.
YED = % Δ in QD
% Δ in Y
YED can be positive or negative, depending on whether it is a normal
good or an inferior good.
Link
Normal and inferior goods were Normal goods
With normal goods, as income rises so does demand. Income and
introduced in 2.1 “The demand
demand are directly related. Similarly, if income falls, less will be bought.
for goods and services”, when
explaining how changes in income This means that YED will be positive for normal goods.
could affect the demand for a
For example, if a 10% increase in incomes results in a 6% increase in
product.
the demand for washing machines:
YED = +6 = +0.6
+10
Some goods will have higher values of YED than others.
Luxury goods (sometimes called superior goods), such as holidays, will
usually have higher values of YED than other normal goods such as
food. If a person’s income rises by 50%, the increase in their quantity
demanded for holidays may be 60% but the increase in their quantity
demanded for food may only be 20%. Therefore, as income rises, it is
likely that a higher percentage of income will be spent on holidays and
a lower percentage on food.
Inferior goods
Inferior goods have negative YED.
This is because income and demand are inversely related. For
example, if income rises, demand falls. If a 5% increase in income
results in a 2% decrease in demand for second-hand clothes:
YED = −2 = –0.4
+5
32
Cross elasticity of demand

Another type of elasticity is concerned with how changes in the price
of one good affect the demand for another good. There are three
possibilities.
• Substitute goods
• Complementary goods
• No relationship
Cross elasticity of demand (XED or CED) is a measure of the
Key term
percentage change in quantity demanded of one good as a result of a
given percentage change in the price of another good, or simply, the Cross elasticity of demand: a
responsiveness of quantity demanded of one good to a change in the measure of the percentage change
price of another. in quantity demanded of one good
as a result of a given percentage
The following formula is used to calculate cross elasticity of demand:
change in the price of another good,
percentage change in quantity demanded
of good A or simply, the responsiveness of
Cross elasticity of demand =
percentage change in price of good B quantity demanded of one good to
Using accepted abbreviations, this can be shortened to: a change in the price of another.
XED = % Δ in QD of A
% Δ in P of B
XED can be positive or negative, depending on whether the goods are
substitute goods or complementary goods. Link
Substitute and complementary
Substitute goods goods were introduced in 2.1 “The
With substitute goods, a rise in the price of one good results in more
demand for goods and services”,
being demanded of the other.
when explaining how changes in
For example, if the price of Good A rises, fewer people will buy Good the price of a related good or service
A and more will buy an alternative such as Good B instead. Similarly, could affect the demand for a
if the price of a good falls, fewer people will buy substitute goods. product.
This means that XED will be positive for substitute goods.
For example, if an 8% increase in the price of one brand of mobile
phone results in a 6% increase in the demand for another:
+6
XED = +8 = +0.75
Two products which are good substitutes are likely to have a higher
value for XED. This is because a change in the price of one good will
have a large impact on the demand for the other good. This is shown
in the numerical example for mobile phones. Some people may be
loyal to a particular brand of mobile phone but otherwise, a change in
price will encourage them to switch brands.
Complementary goods
With complementary goods, a rise in the price of one good results in
less being demanded of the other.
For example, if the price of Good A rises, fewer people will buy
Good A and also fewer people will buy Good B to use with it.
Similarly, if the price of a good falls, more people will buy the
complementary good.
33
2 How markets work
This means that XED will be negative for complementary goods.

Quantitative skills
For example, if a 6% increase in the price of mobile phones results in
You should be able to calculate and
a 3% decrease in the demand for mobile-phone cases:
interpret numerical values of PED,
–3
YED and XED. XED = +6 = −0.5
Two products which go together well are likely to have a higher
(negative) value for XED. For example, the goods will be closer
complementary goods if their XED is −0.7 than if XED is −0.2.
No relationship
If there is no relationship between the two products, XED will be zero.
If there is little connection between the products, XED will be close
to zero.
For example, a 5% change in the price of tables may have no effect
on the demand for bus travel. This is because tables and bus travel are
neither substitute goods nor complementary goods.
Progress questions
4 If YED is +0.3, what type of good is it?
5 If XED is −0.3, are the goods in competitive or joint demand?
6 You are a manufacturer in an emerging economy. Would you prefer your
product to have a high or low value for YED? Explain your answer.
34
2.3 The supply of goods and services

➔ factors which determine the supply of a good or service
➔ how a supply curve shows the relationship between price and quantity supplied
➔ how higher prices imply higher profits and that this will provide the incentive to expand
production
➔ causes of shifts in the supply curve.
Supply Key terms

Supply is the quantity that firms are able and willing to sell at a given
price in a given period of time. It may not be the same as the amount Supply: the quantity that firms are
produced. Wages and transport costs may be higher than the revenue able and willing to sell at a given
a farmer will receive from harvesting and selling their grain crop. It price in a given period of time.
may then be left in the fields for animals to eat. This is not part of Profit: total revenue minus total
supply unless the grain is available for sale. cost.
The market supply is the total amount that all the individual firms of
a product are able and willing to sell at a given price in a given period
of time.
Factors which determine the supply of a good

or service
The price of the good or service Activity
As a rule, the higher the price, the higher the quantity supplied Find out about a business in your
and the lower the price, the lower the quantity supplied. As price local area. Have its sales increased
increases, firms are willing to offer more for sale. This is because if or decreased in recent years and
prices are higher, they are likely to make a higher profit. This provides why? Alternatively, look up the
the incentive to expand production. The higher price will also attract accounts of a well-known company
new firms into the market. to find this information.
Profit is total revenue minus total cost. In Economics, it is often
assumed that firms will aim to maximise profit.
In the example above, if the price of grain increases, the farmer may
then be willing to harvest and sell their crop. The difference between
their total revenue and their costs has increased.
This direct relationship between price and quantity supplied (where
price and quantity supplied move in the same direction) can be shown
in diagrams (see Figures 2.3.1 and 2.3.2).
A supply curve shows the relationship between price and quantity
supplied in a given time period. If the price of the good or service
changes, this is shown as a movement along the supply curve. In
Figure 2.3.1, as price rises from p1 to p2, the quantity supplied rises
from q1 to q2. This movement along the supply curve is called an
extension of supply.
35
2 How markets work
If the price falls from p3 to p4, as in Figure 2.3.2, the quantity supplied
falls from q3 to q4. This movement along the curve, due to a fall in
price, is called a contraction of supply.
P Supply (S) P Supply (S)
p2
p3
p1 Extension
of supply p4
Contraction
of supply
O q1 q2 Q O q4 q3 Q
▲ Figure 2.3.1: An extension of supply ▲ Figure 2.3.2: A contraction of supply
Conditions of supply
Factors which determine the supply of a good, other than the price of
the good, are known as the conditions of supply. These include:
• costs of production
• productivity
• technical progress
• number of firms in the market
• weather and other events
• indirect taxes and subsidies.
Costs of production
Costs of production include:
• wages
• raw materials
• energy
• transport
• interest on loans.
If costs of production rise, for example, higher oil prices increase the
cost of transport, the firm will want to charge a higher price than
before for a particular quantity of their product. Another way of
looking at this is to say that, at any given price, firms will be willing to
offer less for sale. Supply will decrease at each and every price. Higher
costs may make it unprofitable for some firms to continue to supply
the product at a given price. They may then leave the market, further
reducing supply.
Similarly, if costs fall, for example if the price of raw materials falls,
then supply is likely to increase.
Productivity
Productivity measures how much each factor of production produces
in a given time. For example, labour productivity is how much
a worker produces in a given time. Labour costs are affected by
36
The supply of goods and services
wages and the amount workers produce. If wages stay the same but
productivity increases, for example because of increased training, Key terms
labour costs per unit produced will fall. This will encourage an Productivity: how much a factor
increase in supply. of production produces in a given
time.
Technical progress
Technical progress may lead to the development of better machines or Labour productivity: how much a
methods of production. This may help the firm to produce goods more worker produces in a given time.
quickly and cheaply, increasing supply. Technical progress is another Indirect tax: a tax on spending.
reason for higher labour productivity. However, this will often happen
over a long period of time. Subsidy: a payment to producers
to reduce costs and increase
Number of firms in the market supply.
Another factor that can affect the quantity supplied at a given price
over a period of time is the number of firms in the market. Other
things being equal, if firms leave the market, perhaps if the owner Link
decides to retire, supply will decrease. If firms join or leave the market There is more information on
for reasons other than a change in the price of the product, the supply productivity in 3.1 “Production and
curve will shift. If more firms join, the curve shifts to the right. productivity”.
Weather and other events

The output of many goods, particularly agricultural goods, depends on
the weather. Good weather will increase supply and bad weather will
reduce it.
There may be other factors that affect supply at different times, such as
wars or strikes.
Indirect taxes and subsidies

Indirect taxes
An indirect tax is a tax on spending. In many countries, this is
an important source of government income. The firms have to pay
money to the government, which adds to their costs in the same way
Link
as higher wages for example. This will reduce supply. The use of indirect taxes and
subsidies is explained in 5.7
Subsidies
A subsidy is a payment to producers to reduce costs. This will increase “Government intervention in
supply at any given price, shifting the supply curve to the right. markets”.
Movements along a supply curve and shifts

in the supply curve
Movements along the supply curve
As happens with demand, if the price of a product changes, this causes
a movement along the supply curve because the supply curve shows
how much will be supplied at different prices. If there is a change
in any other factor that influences the supply of a product except its
price, then there is a shift of the supply curve.
Shifts of the supply curve

If there is a change in productivity, technical progress, the number of
firms in the market, weather, indirect taxes, subsidies or any other
37
2 How markets work
factor that could affect the costs of production, then the whole supply
curve will shift.
A shift to the right shows an increase in supply, where at each and
every price more is supplied than before. Similarly, a shift to the left
shows a decrease in supply, where less is supplied at each and every
price.
For example, in Figure 2.3.3 after the supply curve for shirts has
shifted from S1 to S2, at price p1, supply has increased from q1 to q2.
This may be because of higher productivity.
Similarly, in Figure 2.3.4 after the supply curve for watermelons has
shifted from S3 to S4, at price p2, supply has fallen from q3 to q4. This
may be because of cold weather.
P S1 S2 P S4 S3
p1
p2
O q1 q2 Q O q4 q3 Q
▲ Figure 2.3.3: An increase in supply ▲ Figure 2.3.4: A decrease in supply
Progress questions
1 Explain why a supply curve slopes upwards from left to right.
2 Will a subsidy increase or decrease supply?
Case study: Problems hit Madagascar’s vanilla crop

Vanilla is used in cooking in many parts of the world.
Madagascar, an island in the Indian Ocean, produces 80% of
the world’s supply of vanilla. In 2017, the island was hit by
Cyclone Enawo. This was followed by a major drought. Many
of the flowers which produce the vanilla seed pods were
destroyed. In the next year, the price of vanilla rose from
$400 to $600 per kilo.
1 On a diagram, should the problems in the vanilla
market, caused by the weather, be shown as:
• a contraction of supply
• an extension of supply
• a shift of the supply curve to the left
• a shift of the supply curve to the right?
Explain why.
2 Draw a diagram to show the effect of the higher price ▲ Figure 2.3.5: Vanilla
of vanilla on the supply of food products which contain
vanilla.
38
2.4 Price elasticity of supply

➔ the meaning of price elasticity of supply
➔ factors that influence price elasticity of supply.
In the same way that PED measures how much demand changes in
response to a change in price, price elasticity of supply (PES) is a Key term
measure of the percentage change in quantity supplied as a result of Price elasticity of supply: a
a given percentage change in price, or simply, the responsiveness of measure of the percentage change
quantity supplied to a change in price. The formula is: in quantity supplied as a result of a
PES = percentage change in quantity supplied given percentage change in price,
percentage change in price or simply, the responsiveness of
Using accepted abbreviations, this can be shortened to: quantity supplied to a change in
PES = % Δ in QS price.
% Δ in P
In most situations, a rise in price will increase the quantity supplied
and a fall in price will reduce it.
Quantitative skills
Elastic and inelastic supply When calculating values for the
Since price and quantity supplied move in the same direction, this four different types of elasticity,
means that PES will be positive. remember that the percentage
In a similar way to PED, if the percentage change in price is less than
change in quantity is always on
the percentage change in quantity supplied, supply is said to be elastic. the top of the equation. This applies
If the percentage change in price is greater than the percentage change whether it is the percentage change
in quantity supplied, supply is said to be inelastic. in quantity demanded of the
same good, quantity demanded of
Examples another good or quantity supplied.
In the diagram below (Figure 2.4.1), price has risen from $8 to $10. As The money variable is always on the
a result, the quantity supplied has risen from 20 to 40 units. bottom. This applies whether it is the
1. What is the value of PES? percentage change in the price of
that good, another good or income.
2. Is supply of the product elastic or inelastic?
Another way to remember which
P ($)
way around the figures should be
20 S
put is that the initial percentage
16 change (the independent variable)
12
is on the bottom and what is being
affected (the dependent variable)
8 is on the top of the equation.
4
O 20 40 60 80 100 Q
▲ Figure 2.4.1: Calculating PES

1. The percentage rise in price is 25% (+25) and the percentage rise in
quantity supplied is 100% (+100).
PES = +100 = +4
+25
39
2 How markets work
2. The percentage change in quantity supplied is greater than the

percentage change in price, so supply is elastic.
If supply is elastic, PES is greater than 1.
The following graph (Figure 2.4.2) and calculation show inelastic supply.
P ($) S
20
16
12
O 20 40 60 80 100 Q
90
▲ Figure 2.4.2: Inelastic supply
If price falls from $20 to $16, quantity supplied falls from 100 to
Quantitative skills 90 units. Here the percentage change in price (–20%) is greater than the
Look again at Figures 2.4.1 and percentage change in quantity supplied (–10%), so supply is inelastic.
2.4.2. An elastic supply curve PES = –10
starts at the vertical axis and an –20 = 0.5
inelastic supply curve starts at the If supply is inelastic, PES is less than 1.
horizontal axis.
Perfectly elastic, perfectly inelastic and unit elasticity
There are three extreme categories of PES, shown below.
P P P S
S
S
O Q O Q O Q
▲ Figure 2.4.3: Perfectly elastic ▲ Figure 2.4.4: Perfectly inelastic ▲ Figure 2.4.5: Unit elasticity
If supply is perfectly elastic, there could be any supply at a particular

Link price but none at any lower price. Firms will supply whatever is
A firm in a perfectly competitive demanded at the given price or above.
labour market has a perfectly Again, like demand, if supply is perfectly inelastic, it stays the same at
elastic supply of labour at the all prices. The percentage change in supply is zero, giving a value for
market wage rate. This is covered PES of zero. If a sports venue or theatre has a fixed number of seats,
in the A2 part of the course. its supply will be perfectly inelastic.
If supply is of unit elasticity, the percentage change in supply is the
same as the percentage change in price. For example, a 10% rise in
price causes a 10% rise in supply. PES will be +1. This applies to any
straight line from the origin.
40
Price elasticity of supply
▼ Table 2.4.1: Summary table for PES

Activities
Category Relationship between % changes in P and QS Value
Perfectly elastic QS falls to zero after any fall in P PES = ∞ Draw price and quantity axes with
prices labelled from 0 to $10 and
Elastic % change in QS > % change in P PES > 1
quantity from 0 to 20 units. Draw
Unit elasticity % change in QS = % change in P PES = 1
two straight-line supply curves
Inelastic % change in QS < % change in P 1 > PES > 0 which start at the origin. S1 ends
Perfectly No change in QS after any change in P PES = 0 at 10 units and $10. S2 ends at
inelastic 20 units and $5. Pick two points
on curve S1 and calculate the
Factors that influence PES value of PES between the two
In a similar way to demand, whether PES is elastic or inelastic depends prices. It doesn’t matter whether
on how easy it is to change the supply of the good or service in response the price rises or falls. Repeat the
to a change in the price of the product. This depends on, for example: experiment for supply curve S2.
• availability of stock 1 What were the answers for PES?

• spare capacity 2 What category of PES is this?
Check back to the text to confirm
• impact on costs
if your answers are correct.
• nature of product
• time
• state of the economy. Quantitative skills
You should be able to calculate and
Availability of stock interpret numerical values of PES.
Many firms keep spare supplies of their product in case there is a
need for more. They may also add to these stocks if they cannot sell
everything they have produced. If firms have stock available, they will
be able to increase their supply if the price rises, making supply elastic.
If the product can be stored, if price decreases, firms may add to their
stock, so it can be sold later.
If the product cannot be stored easily and cheaply, supply will be less
elastic. For example, fresh milk only lasts for a few days. Tinned food
will usually last much longer. The supply of fresh milk is likely to be
inelastic but the supply of tinned food is likely to be elastic.
Spare capacity
If a firm has spare capacity, it is able to change the amount it produces
more easily than if it is working at full capacity. For example, if price
rises, it will be able to increase production, by bringing its spare factors
of production into use, making supply elastic.
If the firm is working at full capacity, it will be more difficult to
increase output. All the machines may be in use. This will make
increasing output more difficult. It may take time to obtain more
machines, or other factors of production, to increase capacity.
Impact on costs
If the cost of producing extra goods is more expensive than the current
Link
cost per item, firms may be unwilling to increase production. For The cost of producing an extra
example, workers may have to be paid a higher wage rate to work good, its marginal cost, is covered
extra hours. This makes increased production less profitable and may in the A2 part of the course.
make supply inelastic, at least in the short run.
41
2 How markets work
Nature of product
For some products, particularly agricultural products or minerals,
supply will be inelastic because it takes time to increase supply. For
example, rice usually takes between four and five months to grow.
It would take time to reduce or increase the amount of rice available
in response to a decrease or increase in price. Similarly, if the price of
copper rose, it will take time to find and mine new areas of copper.
Time
The longer the time period the more elastic the supply. This is because
there will be more time for firms to change their supply by changing
Key terms their factors of production. Also, firms can more easily enter or leave
the market.
Short run: the time period when
at least one factor of production is In Economics, there are two main time periods, the short run and the
fixed in supply. long run.
Long run: the time period when all In the short run, at least one factor of production is fixed in
supply. For example, it may only be possible to increase or decrease
factors of production are variable.
production by changing the amount of labour. Supply is likely to be
inelastic.
Case study: Gepetto’s In the long run, all factors of production are variable. It is possible to
toys change all the factors of production in response to changes in price.
Supply will be elastic.
Gepetto makes wooden toys for
children. He employs one other The short run and long run are not set periods of time in terms of
worker for three days a week. weeks or years. They will vary according to the product. For example,
Wooden toys are becoming more a window-cleaning service could be set up or closed down much more
popular as some people are quickly than a power station producing electricity.
concerned about the impact of Sometimes, a third time period is included – the very short run or
plastic on the environment. The momentary period. This refers to the supply available at that time,
price of wooden toys has increased which cannot be changed. For example, the fish delivered to a
by 5% in the last month and Gepetto market in the morning is limited to that quantity. Supply is perfectly
believes that the price will increase inelastic.
even more in the next year.
1 What would you advise him to
State of the economy
This is related to the spare capacity of the country as a whole. If the
do and why?
economy has spare capacity, for example unemployment is high, the
2 Using your knowledge and supply of many goods and services will be elastic. This is because firms
understanding of the factors will find it easier to obtain extra resources to increase production if
that influence price elasticity price increases.
of supply, what does your
advice depend on? If the economy is working at full capacity, it will be more difficult and
maybe more expensive to obtain the scarce factors of production to
increase supply.
Progress questions
1 If PES is 1.5, is supply elastic or inelastic?
2 If supply is perfectly inelastic, what is the change in total revenue if
demand increases causing price to rise by 4.5%?
3 If PES is 0.3 and the change in quantity supplied is a decrease of 6%, what
▲ Figure 2.4.6: A wooden toy is the percentage change in price?
42
2.5 The determination of market prices

➔ how the interaction of demand and supply determines equilibrium prices in a market
economy
➔ the difference between equilibrium and disequilibrium
➔ why excess demand and excess supply lead to changes in price
➔ causes of fluctuations in commodity prices, including speculation.
How the interaction of demand and supply Link

determines equilibrium prices in a market
This section brings together the
economy content of 2.1 “The demand for
In a free market economy, where there is no intervention by the goods and services” and 2.3 “The
government, the price of a product is determined by the market supply of goods and services”. It
forces of demand and supply. also draws on part of 2.2 “Price,
As price rises, the quantity demanded falls and the quantity supplied income and cross elasticities of
rises. Therefore, there will usually be one price where demand and demand” and 2.4 “Price elasticity of
supply cross. This is the price where demand and supply are equal. supply”.
This equilibrium price is also known as the market-clearing price P
because all the products available for sale at this price will be sold. S
The amount sold at the equilibrium price is the equilibrium
quantity.
p
At equilibrium, there is no tendency to change, unless there is a shift
in either demand or supply. The equilibrium price and quantity for a
product can be seen in Figure 2.5.1 at p and q.
D
Difference between equilibrium and disequilibrium
O q Q
Disequilibrium refers to a situation where two related variables, such
as supply and demand, are not equal. There will be forces at work that ▲ Figure 2.5.1: Equilibrium
will lead to a change in the price and quantity sold in this case.
Key terms
P
S Market forces: demand and supply,
which determine the price and
Excess supply
quantity sold of products in a
p2 market economy.
Extension Contraction
of demand of supply Equilibrium price: the price where
p
Extension Contraction
demand and supply for a product
of supply of demand are equal.
p1 Equilibrium quantity: the quantity
where demand and supply for a
product are equal.
D
O x v q w y Q Disequilibrium: where there are
excess demand forces at work that will lead to a
change in a variable.
▲ Figure 2.5.2: Equilibrium and disequilibrium
43
2 How markets work
Key terms Why excess demand and excess supply lead to

changes in price
Surplus/excess supply: where
supply is greater than demand at a Figure 2.5.2 shows both equilibrium and disequilibrium in the market
for pencils. If the market is in disequilibrium, it will usually move
given price.
towards equilibrium.
Shortage/excess demand: where
• p is the equilibrium price, where S = D. q is the equilibrium
demand is greater than supply at a quantity sold at this price.
given price.
• At prices below p, for example p1, there is a shortage/excess
demand of pencils of y – x, which can be written as xy. This is
because at p1, the quantity demanded of pencils at y is greater
than the quantity supplied of x. In this case, price will tend to
rise towards equilibrium. As price rises, this causes a contraction
of demand and an extension of supply of pencils. This is because
buyers will be less willing and able to buy pencils but suppliers will
want to sell more, attracted by higher profits.
• At prices above p, for example p2, there is a surplus/excess
supply of pencils of w – v or vw. This is because at p2, the quantity
supplied of pencils at w is higher than the quantity demanded of v.
As a result, price falls towards equilibrium. As price falls, this causes
an extension of demand and a contraction of supply of pencils. In
this case, buyers are able and willing to buy more but there is less
incentive for suppliers to sell as many.
Case study: The market for strawberries

There are several small stallholders in a local market selling
fruit and vegetables, including strawberries. At a higher
price, they will offer more for sale, to make more profit.
They have also noticed that the demand for strawberries
changes with price.
Table 2.5.1 shows the demand and supply of strawberries
per day at different prices.
▼ Table 2.5.1: Demand and supply of strawberries per day
Price per kg (€) 1 2 3 4 5 6
Demand (kg) 12 10 8 6 4 2 ▲ Figure 2.5.3: Strawberries for sale
Supply (kg) 2 4 6 8 10 12
3 If the stallholders charge €5 per kg, will there be excess
1 Use the information in the table to draw a diagram supply or demand and by how much? Explain how the
showing the demand and supply for strawberries. equilibrium price will be restored.
2 What is the equilibrium price of strawberries and how 4 What will happen if the stallholders charge €2 per kg?
many kg will be sold at this price? What would you advise them to do and why?
44
The determination of market prices
Use of demand and supply diagrams to analyse

causes of changes in market prices
Section 2.1, “The demand for goods and services”, covered reasons why
a demand curve may shift, either to the right, if there is an increase in
demand, or to the left, if demand decreases. These reasons included
changes in income, wealth, the price of related goods and services,
individual preferences, population, or any other factor that could
affect the demand for a product except the price of that good.
An increase in demand
Figure 2.5.4 shows what happens when there is an increase in
demand. For example, a rise in population may have increased the
demand for rice from D1 to D2. Demand is now higher at each and
every price.
P
Quantitative skills
S
When drawing diagrams in
Extension
of supply Economics, if there is more than one
p2 Contraction of a particular type of curve, number
of demand them in a logical order. For example,
p1 in Figure 2.5.4, the original demand
curve is D1 and the new demand
curve is D2. In the same way, the
old equilibrium price and quantity,
D2
where D1 and S cross, are labelled p1
D1
and q1. The new equilibrium is at p2
O q1 q2 x Q and q2, where D2 and S cross. Also,
Excess demand when including a diagram as part of
your analysis, refer to it fully in your
▲ Figure 2.5.4: An increase in demand explanation.
What happens next? How does the market reach a new equilibrium?
At the old equilibrium price of p1, there is excess demand of q1x
because demand is now higher than supply. Price will tend to rise
because buyers who cannot obtain the product will bid up its price. Get it right
This will cause an extension of supply, as sellers hope to make more
profit but there will also be a contraction of demand, as some buyers When explaining what happens
are no longer able and willing to pay a higher price for rice. The after a shift in demand or supply,
market will reach a new equilibrium price of p2 where q2 is sold. the excess demand or supply is at
the old equilibrium price, not at the
If demand increases, both the equilibrium price and the
new price.
equilibrium quantity sold will increase.
45
2 How markets work
A decrease in demand
Figure 2.5.5 shows what happens when there is a decrease in demand.
For example, a fall in income may have decreased the demand for new
cars from D1 to D2. Demand is now lower at each and every price.
P
p1 Contraction
of supply
p2
Extension
of demand
D1
D2
O y q2 q1 Q
Excess supply
▲ Figure 2.5.5: A decrease in demand
At the old equilibrium price of p1, there is excess supply of yq1 because
supply is now higher than demand. Price will tend to fall. This will
cause a contraction of supply as sellers are likely to make less profit
and there will be an extension of demand as more buyers are able and
willing to buy new cars at a lower price. The market will reach a new
equilibrium price of p2 where q2 is sold.
If demand decreases, both the equilibrium price and the
equilibrium quantity sold decrease.
An increase in supply
Section 2.3, “The supply of goods and services”, covered reasons why
a supply curve may shift, either to the right if there is an increase
in supply or to the left if supply decreases. These reasons included
changes in productivity; technical progress; the number of firms in
the market; weather; indirect taxes; subsidies; or any other factor that
could affect the costs of production.
P S1
S2
Extension
of demand
p1
Contraction
p2 of supply
O q1 q2 x Q
Excess supply
▲ Figure 2.5.6: An increase in supply
46
Figure 2.5.6 shows what happens when there is an increase in supply.

For example, technical progress may make computers cheaper to Get it right
produce, so they are more profitable to sell at each and every price. When using a demand and supply
This increases the supply of computers from S1 to S2. diagram to help analyse causes of
At the old equilibrium price of p1, there is excess supply of q1x because changes in market prices:
supply is now higher than demand. Stocks of unsold computers will • draw and label the axes, the
start to build up and price will tend to fall. This will cause a contraction original demand and supply
of supply as sellers are then likely to make less profit and there will be curves and the coordinates
an extension of demand as more buyers are able and willing to buy
for the equilibrium price and
computers at a lower price. The market will reach a new equilibrium
quantity
price of p2 where q2 is sold.
• identify whether the change
If supply increases, the equilibrium price falls and the affects demand or supply;
equilibrium quantity sold rises. if there is more than one
factor changing, for example
A decrease in supply population and technical
Figure 2.5.7 shows what happens when there is a decrease in supply. progress, then both the
For example, a rise in wages of farm workers may have decreased the demand and supply curves
supply of potatoes from S1 to S2. Supply is now lower since it is less may shift
profitable at each and every price.
• identify whether it increases or
P
decreases demand or supply
S2
• draw the new curve, label it
S1 appropriately and then show
Extension the new equilibrium price and
of supply quantity
p2
• to make it clearer, draw arrows
p1 Contraction to show the direction of the
of demand shift and the changes in
equilibrium price and quantity.
D
Activities
O y q2 q1 Q 1 Draw a diagram to show the
Excess demand effects on the equilibrium price
▲ Figure 2.5.7: A decrease in supply and quantity sold of computers
of an increase in population
At the old equilibrium price of p1, there is excess demand of yq1
and technical progress.
because demand is now higher than supply. As some buyers who
2 What does the change in
cannot obtain potatoes bid up the price, it will tend to rise. This will
cause an extension of supply as sellers hope to make more profit but
equilibrium price depend on?
there will also be a contraction of demand as fewer buyers are then
able and willing to pay a higher price for potatoes. The market will
reach a new equilibrium price of p2 where q2 is sold.
If supply decreases, the equilibrium price rises and the
equilibrium quantity sold falls.
Therefore, when there is a shift in one or both of the demand and
supply curves, the market price and quantity will adjust to a new
equilibrium.
47
2 How markets work
Significance of different price elasticities of

demand and supply
When a demand or supply curve shifts, there will be a change in the
equilibrium price and quantity sold. However, how much the price
and quantity change will depend on the price elasticities of demand
and supply for the product.
Significance of PED
Figure 2.5.8 shows what happens to price and quantity sold after
an increase in supply according to whether demand is elastic or
inelastic.
P S1
S2
p1
pe
pi
De
Di
O q1 qi qe Q
▲ Figure 2.5.8: Significance of PED when supply
changes
The market for mangoes starts in equilibrium at p1 and q1. As a result
of a subsidy, supply increases to S2. This will reduce the equilibrium
price and raise the quantity sold at that price.
If demand is elastic, as shown by the demand curve De, the percentage
change in demand to qe is greater than the percentage change in price
to pe. If there are substitutes for mangoes, people will buy many more
mangoes, even when the price falls by a small amount.
If demand is inelastic, as shown by the demand curve Di, the
percentage change in demand to qi is less than the percentage change
in price to pi. Even a large fall in the price of the product will lead to
relatively little more being bought.
Significance of PES
Similarly, Figure 2.5.9 shows what happens to price and quantity sold
after an increase in demand according to whether supply is elastic or
inelastic.
48
P Si
pi
Se
pe
p1
D1 D2
O q1 qi qe Q
▲ Figure 2.5.9: Significance of PES when demand

changes
The market for chicken starts in equilibrium at p1 and q1. As a result
of a successful advertising campaign, demand increases to D2. This will
raise both the equilibrium price and the quantity sold at that price.
If supply is elastic, as shown by the supply curve Se, the percentage
change in supply to qe is greater than the percentage change in price
to pe. If it is easy to increase the supply of chicken, farmers will want to
sell much more chicken, even when the price rises by a small amount.
If supply is inelastic, as shown by the supply curve Si, the percentage
change in supply to qi is less than the percentage change in price to pi.
Even a large rise in the price of the product will lead to relatively little
more being available for sale.
If demand or supply is elastic, there will be a greater percentage
change in quantity sold than price.
If demand or supply is inelastic, there will be a greater percentage
change in price than quantity sold.
Progress questions
1 What happens to equilibrium price and quantity sold if demand increases
and supply is:
i. perfectly elastic
ii. perfectly inelastic
iii. of unit elasticity?
2 If there is a decrease in the supply of oil, is there likely to be a greater
percentage change in price or quantity sold? Why?
3 If incomes rise, what will happen to the price of a normal good? Show this
on a diagram.
4 If wages in the bicycle industry rise by 10% and productivity rises by 50%,
is the equilibrium price likely to rise or fall? Why?
49
2 How markets work
Key term Causes of fluctuations in commodity prices,

including speculation
Commodities: primary products –
raw materials, agricultural or Commodities are raw materials, agricultural or mining products, for
example copper, oil or wheat. They are primary products.
mining products.
Many commodities, especially mining products, are only produced in
certain countries, where they occur naturally. For example, Russia and
Botswana are the world’s leading producers of diamonds.
The climate of a country will determine which agricultural products can
be produced cheaply and in large quantities. For example, parts of Brazil
have just the right temperature and amount of rain to grow coffee.
Commodities are not normally differentiated by brand names and their
price is determined by world demand and supply for the commodity.
There are many factors that can affect the demand and supply of a
commodity. For example, when economies are growing rapidly,
incomes will be rising and people can afford to buy more. This will
increase the demand for raw materials to make more products. For
example, the increased demand for housing and roads in China has
increased the demand for sand and other raw materials.
The supply of many commodities, especially agricultural products,
can be greatly affected by the weather. It takes time to grow another
crop or to find and set up another diamond mine. For these reasons,
the supply of commodities is often inelastic, at least in the short run.
If supply is inelastic and demand changes, there will be a more than
proportionate change in price.
P
S2 Demand may also be inelastic if the resource has no good substitutes.
S1 Any change in supply will have a large impact on price.
p2 This can lead to large fluctuations in commodity prices. Figure 2.5.10
shows what happens to price and quantity sold after an increase in
demand and a decrease in supply if both are inelastic.
With incomes rising, the demand for pasta in some emerging
p1 economies has increased considerably. This will raise the demand
D2 for durum wheat needed to make pasta. If there is poor weather in
D1 Canada, this will reduce the supply of this type of wheat.
O q2 q1 Q
In Figure 2.5.10, the old equilibrium price is p1, where q1 is sold. If
▲ Figure 2.5.10: Price change when demand increases and supply decreases, the price of wheat will rise. If
demand and supply are inelastic both demand and supply are inelastic, this price rise to a new equilibrium
of p2 will be much greater than if demand and supply are elastic.
Activities Whether the quantity sold decreases, increases or stays the same
depends on how much demand and supply change. In Figure 2.5.10,
Draw a diagram with demand and the equilibrium quantity sold decreases because supply has fallen by
supply both elastic. more than demand has risen.
1 What happens to the quantity
sold if both demand and supply Speculation
increase? Speculation is the buying or selling of an asset to make a profit,
2 What does the change in price by predicting that the price will rise or fall in the future. An asset is
depend on? something of value that is owned.
50
Commodities, such as oil or gold, are example of assets that often

fluctuate in price. If a person or business expects the price of gold to Key terms
rise, they may buy gold now in the hope of selling it at a higher price Speculation: the buying or selling
in future. They are not interested in using the gold in production but of an asset to make a profit, by
just to make money from the rise in price. This is a risk, since they predicting that the price will rise or
would lose money if they are wrong and prices fall. fall in the future.
This demand for speculative reasons adds to the total demand for the Asset: something of value that is
commodity. If many people buy gold expecting its price to rise, even owned.
if nothing else changes, this extra demand may cause the price to rise.
Some people may then choose to sell, making the profit they expected. Asset bubble: when the price
This will increase the supply of gold, which will reduce its price. When of a commodity or other asset
a commodity is bought for speculative reasons, this will be another increases quickly over a short
cause of fluctuations in price. period of time, usually due to
speculation.
Sometimes, the price of a commodity or other asset can increase
quickly over a short period of time, usually due to speculation. This
is called an asset bubble. Speculators may buy, for example, houses
expecting the price to rise even more.
As the price rises, people expect that it will rise even more. This
increases demand and raises the price, encouraging others to buy
the asset. If the price becomes much higher than the asset is really
worth (for example, house prices rise much faster than incomes), the
speculative bubble may then burst as many people sell the item and
the price falls rapidly.
Case study: Tulip mania

One of the first asset bubbles happened in the seventeenth
century in the Netherlands. Tulips are the country’s national
flower and were first brought to the country in the late
1500s. At the time, the Netherlands was the richest country
in Europe. Many people had money to spare and as new
varieties of tulip were developed, people started to buy and
sell the bulbs, more for profit than to grow the flowers.
Demand was higher than supply and by the 1620s, the price
of tulip bulbs, particularly rare types, was rising steadily. This
encouraged even more people to buy the bulbs, hoping that
the price would rise even more. Some people mortgaged their
homes to buy bulbs to sell at a profit.
▲ Figure 2.5.11: Tulips
At the beginning of 1637, the price of one popular bulb rose
from 125 to 1500 florins. Soon after, people started to doubt 2 Find out about another asset bubble. When and why
whether the price could continue to rise. As people lost did it start? When and why it end? Possible examples
confidence and started to sell, the price collapsed. Many include the Wall Street Crash, the dotcom bubble
families lost all their money. and housing market bubbles in various countries at
different times.
1 Calculate:
i. 1500 divided by 125
ii. the percentage increase from 125 to 1500 florins
iii. what percentage 125 is of 1500, to one decimal place.
51
2.6 The interrelationship between markets

➔ how changes in one market are likely to affect other markets
➔ joint demand, competitive demand, composite demand, derived demand and joint supply.
Link How changes in one market are likely to affect

other markets
Joint demand and competitive
demand were explained in 2.1 “The Products can be related in a number of different ways. These include
the goods being in joint demand; competitive demand; composite
demand for goods and services”.
demand; derived demand; and joint supply.
If supply or demand changes in one market, this will affect the price
and quantity sold of that good. This will then affect the demand or
supply of related goods, changing their price and quantity sold in the
same or a different way, depending on the relationship between the
goods.
Joint demand
Goods in joint demand/complementary goods are products that are
bought or used together. If the demand for one good increases, so
will demand for the other. Similarly, if the demand for one good falls,
demand for the other will also fall. Examples include electric cars and
electricity, torches and batteries, and printers and ink cartridges.
P P
S1 S
S2
p1 p2
p2 p1
D2
D
D1
O q1 q2 Q O q1 q2 Q
▲ Figure 2.6.1: The market for ▲ Figure 2.6.2: The market for
electric cars electricity
If supply changes for one of the products, due to a change in costs, this
will change its price and quantity sold. This then affects demand for
the other product.
In recent years, there have been increasing concerns about the
effects on the environment of using petrol and diesel as fuel for cars.
Technical progress has led to a fall in the cost of producing electric
cars. This increases the supply of electric cars, as shown by the shift
from S1 to S2 in Figure 2.6.1. This causes excess supply at the old
52
The interrelationship between markets
equilibrium price of p1 leading to the fall in the price and an extension

of demand. More electric cars will be sold, other things being equal. Activities
Electric cars run on electricity. With an increase in the use of electric Draw two diagrams to show the
cars, there will also be an increase in the demand for electricity. The effects of an increase in the cost
demand curve for electricity will shift from D1 to D2 in Figure 2.6.2. of producing electricity on the
This will cause excess demand at the old equilibrium price of p1 and is markets for electricity and for
likely to lead to an increase in the price and quantity sold of electricity. electric cars.
If the products are in joint demand, if demand for one good changes, 1 What happens to the price and
demand for the other will change in the same direction. The extent quantity sold of electricity?
of the change in demand may be different for the two markets. For 2 How does this affect the
example, electricity is used for many other products as well as cars. market for electric cars?
Competitive demand
Goods in competitive demand/substitute goods are alternative
products. If the price of one good rises, so will demand for the other,
as people switch to a cheaper alternative. Similarly, if the price of one
good falls, so will demand for the other. Examples include travelling
by car or bus, potatoes from two different shops and two brands of
toothpaste.
P S2 P
S
S1
p2
p2
p1
p1
D2
D
D1
O q2 q1 Q O q1 q2 Q
▲ Figure 2.6.3: The market for cars ▲ Figure 2.6.4: The market for bus
travel
Figure 2.6.3 shows the effects of a government increasing the tax on

cars. This will increase firms’ costs and shift supply to the left from
S1 to S2. The excess demand at the old equilibrium price is likely to
lead to an increase in price from p1 to p2. This causes a contraction in
demand and fewer cars will be sold at the higher price.
The increased price of cars will encourage people to look for substitutes
and it is likely that the demand for bus travel will rise. This is shown by
the shift from D1 to D2 in Figure 2.6.4. This again causes excess demand
at the old equilibrium price of p1 and is likely to lead to an increase in
the price and quantity of journeys by bus.
Progress questions
1 Draw a diagram to show the effects of a subsidy for bus travel.
2 How is this likely to affect the price and quantity sold of cars?
53
2 How markets work
Key terms Composite demand

Goods are in composite demand if they have more than one use. For
Composite demand: a good which example, the demand for wool is composed of the demand for wool for
has more than one use. carpets, coats, hats and many other goods. Other products in composite
Derived demand: where the demand are milk (including for cheese, cream and butter) and wood
(for boats, furniture and musical instruments).
demand for a factor of production
results from the demand for the An increase in demand for one use will raise the price of the product in
product it makes. composite demand and increase the costs of production for the other
goods it makes.
P P S2
S
S1
p2
p2
p1
p1
D2
D
D1
O q1 q2 Q O q2 q1 Q
▲ Figure 2.6.5: The markets for boats ▲ Figure 2.6.6: The market for
and wood furniture
Figure 2.6.5 shows the effects of an increase in demand for wooden

boats. This also increases the demand for wood to make the boats. In
both cases, the demand curve shifts to the right from D1 to D2. The same
diagram can be used for both wood and wooden boats, although the
prices and quantities for the two goods will differ.
The excess demand at the old equilibrium price is likely to lead to an
increase in price from p1 to p2. This causes an extension in supply and
more wooden boats and wood will be sold at a higher price.
The higher price of wood will increase the costs of firms making other
products that use wood, for example furniture. This is shown by the
shift from S1 to S2 in Figure 2.6.6. This again causes excess demand at
the old equilibrium price of p1 and is likely to lead to an increase in the
price of furniture and a fall in the quantity sold. This will also apply to
other products that use wood.
Derived demand
Goods need resources to make them. Derived demand is where
the demand for a factor of production results from the demand for
the product it makes. For example, wood is in derived demand for
making wooden boats and furniture and the demand for steel leads to
a derived demand for steelworkers.
If the demand decreases for a good, there will be a decrease in demand
for the factors of production that make it. For example, a decrease in
the demand for steel will decrease the demand for steelworkers, and
the raw materials and equipment needed to make steel.
54
The interrelationship between markets
P P
S S
Key term
Joint supply: when the output of
one good results in the output of
p1 p1 another good.
p2 p2
D1 D1 Quantitative skills
D2 D2 A ratio gives one value in proportion
O q2 q1 Q O q2 q1 Q to another. The second number
shows how many times greater it
▲ Figure 2.6.7: The market for steel ▲ Figure 2.6.8: The market for
steelworkers is than the first. For example, if half
as much lead as zinc is found in
Figure 2.6.7 shows the decreased demand for steel and Figure 2.6.8 the same ore, then the ratio of lead
shows the decreased demand for steelworkers (and all the other to zinc is written as 1:2 or 1 to 2.
factors of production used to make steel). In both markets, there will If in a certain quantity of ore there
be excess supply at the old equilibrium price of p1 after a decrease in is 60g of lead and 80g of zinc, this
demand from D1 to D2. If less steel is being produced, there will be cancels down to 3:4 for the ratio of
less demand for steelworkers to make it. This will decrease the lead: zinc.
price and the quantity sold of both steel and the resources needed
to make steel. A question may give a specific
instruction in terms of the final
answer. For example, if asked to
Joint supply calculate the ratio of 60g of lead to
Goods are in joint supply when the output of one good results in 80g of zinc in relation to how much
the output of another good. The products are either produced/found 1g of lead is equal to in terms of
together or one is a by-product of the other (produced when making zinc, to one decimal place, then the
something else). For example, lead and zinc ores are usually found answer would be 1:1.3.
together and when wheat is grown, after the grain has been removed,
the stalks that remain of the crop (straw) can be used for fuel, to feed
animals, or to make baskets.
P P S1
S
S2
p1
p2
p2
p1
D2
D
D1
O q1 q2 Q O q1 q2 Q
▲ Figure 2.6.9: The market for wheat ▲ Figure 2.6.10: The market for straw
Figure 2.6.9 shows the effects of an increase in demand for wheat from
D1 to D2. This causes an increase in the price of wheat from p1 to p2,
which leads to an extension of supply from q1 to q2. The extension in
supply of wheat also results in more straw being supplied. Figure 2.6.10
shows the resulting increase in the supply of straw from S1 to S2
leading to a fall in its price and an increase in the quantity sold.
55
2 How markets work
Case study: The Kenyan flower industry

Flowers grown in Kenya are sold in over 60 countries and the country is the
leading supplier of flowers to the European Union. The Kenyan climate allows
flowers to be grown throughout the year. The industry has been growing steadily
for many years both in terms of the number and value of flowers produced,
although competition is increasing from countries such as Colombia and
Ecuador. There are around 100 000 people working on flower farms as part of
the total of 500 000 jobs in the flower industry in Kenya.
Mwangi and Kimani Flowers have a flower farm near Lake Naivasha. The
business grows roses, lilies and carnations, which are mainly sold abroad.
They employ 50 workers and have a packaging shed where the flowers are
assembled into bouquets. They also produce gift cards which are included with
some of the bouquets of flowers.
1 Use the information in the case study to identify:
i. a pair of complementary goods
ii. a pair of substitute goods
iii. an example of derived demand.
2 What is the ratio of people working on flower farms to the total number
working in the flower industry in Kenya?
3 For each 50 workers employed at the flower farm, how many more jobs in
Kenya is this likely to support?
▲ Figure 2.6.11: The market for flowers
56
2.7 How markets and prices allocate resources

➔ the rationing, incentive and signalling functions of prices in allocating resources and
coordinating the decisions of buyers and sellers in a market economy
➔ how the price mechanism is the way in which the basic economic problem is resolved in a
market economy
➔ advantages and disadvantages of the price mechanism and of extending its use into new
areas of activity.
Factor markets and goods markets Key terms

In a market economy, there are two main markets – for the factors of
production and the final goods and services. There are three economic Factor market: the market for
agents involved in these markets – buyers of goods and services, sellers buying and selling resources/
of goods and services and the owners of the factors of production. factors of production.
The buyers in the factor market are the producers that want these Goods/product market: the market
resources to make goods and services. The sellers in factor market for buying and selling goods and
are the owners of the resources. In the goods/product market, the services.
buyers are the consumers of the goods and services and the sellers Rationing function: the allocation of
are the firms. The firms/producers are therefore involved in both the
scarce resources and finished goods
factor and the goods market.
to those able and willing to pay.
The rationing, incentive and signalling functions Signalling function: the idea
that changes in price provide
There are three main functions of the price mechanism – rationing,
information to buyers and sellers in
incentive and signalling. These help to coordinate the decisions of
a market.
buyers and sellers in a market economy. When the price changes,
these functions affect the decisions of the buyers and sellers in that Incentive function: the idea that
market and what happens to the allocation of the goods and services, changes in price make producers
and factors of production. or sellers of factors of production
The rationing function refers to the allocation of scarce resources more or less likely to sell their
and finished goods to those able and willing to pay. For example, if goods or services.
demand increases, price rises causing some potential buyers to drop
out of the market. If price falls, rationing is less severe and more
people will be able and willing to buy the product. Link
The signalling function is the idea that changes in price provide The price mechanism was
information to buyers and sellers in a market. The changes by many introduced in 1.3 “Scarcity, choice
consumers and producers resulting in a change in the price of a good, and the allocation of resources”,
are brought together as a single piece of information. and the incentive function in 2.3
The incentive function means that changes in price make producers “The supply of goods and services”.
or sellers of factors of production more or less likely to sell their goods
or services. For example, an increase in price will encourage sellers
to supply more because if prices are higher, they are likely to make
a higher profit. Similarly, a fall in prices will provide less incentive to
firms and owners of factors of production to supply more goods and
services.
57
2 How markets work
How the price mechanism is the way in which the

basic economic problem is resolved in a market
economy
The basic economic problem is that resources are scarce but wants are
Link many. Decisions have to be made about how best to allocate these
The economic problem was scarce resources to alternative uses. In a market economy, this is done
explained in 1.3 “Scarcity, choice by supply and demand, through the workings of the price mechanism
and the allocation of resources”. and its functions of rationing, signalling and incentives, with little, if
any, involvement of governments.
Example
As biofuel has become a more popular fuel, there has been an increase
in demand for crops such as sugar cane which can be used to make
biofuel. Figure 2.7.1 shows what happens to the sugar cane and its
related factor markets.
Incentive
function
p2
Rationing
function
p1
D2
D1
O q1 q2 x Q
▲ Figure 2.7.1: The sugar cane market

As demand for sugar cane increases from D1 to D2, there will be excess
demand of q1x. This will force the price upwards. As price rises, this
is signalling to buyers and sellers of sugar cane that something in the
market has changed. The higher price acts as an incentive for suppliers
to offer more sugar cane for sale, causing an extension in supply.
The higher price also acts as a rationing device, since some buyers
will no longer be willing or able to buy the sugar cane at the higher
price. There will be a contraction in demand. Through the functions of
signalling, incentives and rationing, a new equilibrium price of p2 will
be reached where q2 is sold.
These changes also affect the factor market. Figure 2.7.1 could also
represent the demand for the factors of production needed to produce
sugar cane. As demand rises for sugar cane, there will also be an
increase in demand for the factors of production involved, since their
demand is derived from the demand for sugar cane. This will include
the land on which to grow the sugar cane, as well as labour and
equipment.
58
How markets and prices allocate resources
For example, as demand for land to grow sugar cane increases, its
price will rise. This will signal to farmers wishing to grow sugar cane
and owners of land that something has changed in the market. As
price rises the owners of the land will have more incentive to use or
sell their land for sugar cane production. Also, as price rises, some
potential buyers will be rationed out of the market.
Advantages and disadvantages of the price

mechanism
The price mechanism works automatically to allocate scarce resources
to those willing and able to pay. In this way, the choices of millions
of buyers and sellers of millions of products are coordinated, without
intervention from governments.
Adam Smith, the eighteenth-century Scottish economist, referred to
the process as ‘‘the invisible hand of the market”. Individuals act out
of self-interest and the combination of goods and services produced
as a result will benefit society as a whole. It is an impersonal way of
allocating resources, goods and services which is simple and happens
automatically. There is no need for a government or central authority
to be involved, which would use up further resources.
If resource allocation is left to the price mechanism, there is consumer
sovereignty. This means that consumers determine which goods and Key term
services are produced and in which quantities. Spending on a product is Consumer sovereignty: when
a “vote” for more of that good to be supplied. consumers determine what is
There is freedom of choice. Consumers can buy what they want but produced through their spending.
only if they have enough money. Producers can supply what they want
but, to make a profit, they will supply what is in demand. Competition
will help to keep prices low and resources should be used efficiently. No
regulation is needed.
However, the price mechanism also has disadvantages. If left to
the market forces of supply and demand, some products will be
overproduced when compared to what would benefit society. Others
will be underproduced or not produced at all.
Inequality of income and wealth will mean that some people cannot
afford to buy as much as others, or even basic necessities. This is because
goods and services are allocated on the basis of ability to pay, and not
need. This gives people with more income and wealth more influence in
determining what goods and services are provided.
It is assumed that competition between firms will lower prices. In
some markets, large firms may develop. As they try to increase profit, Link
prices may rise. If there are many firms, resources may be wasted on
advertising to persuade consumers to buy from a particular firm. Examples of why markets may fail
to produce the “right” quantity for
If the price mechanism is not used to allocate resources, the government
society are explained in 5.1 “The
or central authority will need to do this for all or some goods and
meaning of market failure”.
services.
59
2 How markets work
▼ Table 2.7.1: Advantages and disadvantages of the price mechanism

Advantages Disadvantages
• Automatic allocation of resources • Some goods/services
• Consumer sovereignty overproduced, underproduced or
• Freedom of choice not produced at all
• Supply of goods/services matches • Some people unable to afford
people’s preferences basic necessities
• Resources used efficiently • Rich people have more influence
• No regulation needed on what is produced
• Potential for large firms to develop
and exploit customers
• Resources wasted on advertising
Case study: Magnificent Margaret

Margaret has a small business,
Magnificent Margaret. She works
from home making birthday cards
to sell in a local shop.
Recently, Margaret introduced a
new shape of birthday card. She
wasn’t sure whether to charge a
higher price or not. She agreed
with the shop owner to start
selling these cards at the same
price as her other cards for three
months. The new shape of card
proved to be popular and sold out
in two months, even though the
shop, with Margaret’s agreement,
increased the price of the cards
after one month.
Using the example of the new ▲ Figure 2.7.2: Birthday cards
shape of birthday card, explain
how the price mechanism works. Include at least two functions of the price
mechanism in your explanation.
Extending the use of the price mechanism into

new areas of activity
In recent years, the use of the price mechanism has been extended to
new areas of activity.
Example 1 – cleaning services provided by the NHS

In the UK, the National Health Service (NHS), funded by the
government, used to provide its own catering and cleaning services.
Since the 1980s, the NHS has employed other firms to do these jobs.
60
How markets and prices allocate resources
Firms bid for the contract, which creates a market in this service.
A firm is then chosen to do the work for a set period of time. It was Key term
hoped that this would result in competition to obtain the work and Unintended consequence: an
then it would be done more cheaply and/or better. unexpected effect of an action.
In the 1990s, there was an increase in hospital infections, some of
which, according to an international study, were linked to cleaning.
This was an unintended consequence, an unexpected effect
of introducing a market for cleaning for the NHS. Unintended Activity
consequences may be good, bad or even lead to the opposite effect.
Investigate another area in
Sometimes, the expected benefits of an action, such as introducing your economy where the price
markets, may be offset or outweighed by unexpected disadvantages. It mechanism has been extended in
is important that there are regular reviews to check the quality of the recent years. Have there been any
service being provided. unintended consequences?
Example 2 – fines for lateness

Many child-care centres charge or fine parents if children are collected
late. A study of six child-care centres in Israel showed that when they
started to charge people for lateness, it did not have the desired effect.
It led to more people arriving late to pick up their children.
Some child-care centres in Canada started charging in the 1980s, to
cover the overtime they had to pay staff. Charging $1 a minute was
intended to encourage people not to be late. It could also pay for the
worker’s time. It was expected that the charge would encourage more
parents to arrive on time.
Before the charges/fines were introduced, parents relied on the
goodwill of the workers to stay late and would usually try to arrive
on time, so they did not exploit this. Now they were able to buy this
time, many viewed it as part of the total cost of the care and made
less effort to arrive on time. They no longer had to feel guilty or
apologise directly to the person who had spent extra time looking after
their child.
Introducing the price mechanism for the additional time had
unexpected/unintended consequences. To be effective, a high charge/
fine must be used.
Progress questions
1 List the three functions of the price mechanism.
2 List at least two advantages and two disadvantages of using the price
mechanism to allocate resources.
61
2 How markets work
Exam-style questions
1 Which one of the following would cause an extension of supply of pineapples?
A A fall in the price of pineapples C A tax on pineapples
B A subsidy on pineapples D An increase in demand for pineapples (1 mark)
2 Rice and pasta are substitute goods. If the price of rice increases, what is likely to
happen to the price and quantity sold of pasta? (1 mark)
Price Quantity sold
A Fall Fall
B Fall Rise
C Rise Fall
D Rise Rise
3 The price of a product rises by 5% and as a result, total revenue rises by 6%. What is the price elasticity
of demand for the product?
A Elastic C Perfectly inelastic
B Inelastic D Unit elasticity (1 mark)
4 Define “market forces”. (3 marks)
5 The quantity supplied of silver rises by 18% as a result of a price rise from $500/kg to $575/kg.
Calculate the price elasticity of supply of silver. (4 marks)
6 In a particular country, there are two main brands of washing powder. The table below shows
the price of one brand, Washo, and the sales of another, Cleano, over a five-year period.
Year Price of Washo Sales of Cleano
($ per kg) (millions of kg)
2015 4 2
2016 4.50 2.3
2017 5 2.2
2018 4.75 2
2019 6 2.4
(i) Explain why changes in the price of Washo might affect the sales of Cleano. [6 marks]
(ii) To what extent do the data suggest that changes in the price of Washo affect
the sales of Cleano? Use the data in the table to support your answer. [6 marks]
7 With the help of a diagram, explain how a fall in the price of copper will affect the market for
copper pipes. (9 marks)
8 Analyse the likely effects on the market for woollen carpets of an increase in popularity of
woollen coats. (12 marks)
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2 How markets work

The operation of markets, market

This section will develop your knowledge and understanding of:

What determines the price of a good or service? Why is the price of

Factors which determine the demand for a good

3 What do you notice? ▲ Figure 2.1.1: A contraction of ▲ Figure 2.1.2: An extension of

A demand curve shows the relationship between price and quantity

The price of complementary goods

Other things being equal (ceteris Individual preferences

Social and emotional factors

Movements along a demand curve and shifts in

Shifts of the demand curve

Case study: Changes in China’s automotive market

This section will develop your knowledge and understanding of:

Demand is affected by many factors. These include the price of the

Price elasticity of demand

If the percentage change in price is less than the percentage change

Perfectly elastic, perfectly inelastic and unit elasticity

▲ Figure 2.2.3: Perfectly elastic ▲ Figure 2.2.4: Perfectly inelastic

▲ Figure 2.2.5: Unit elasticity

If demand is perfectly elastic, there could be any demand at a

Key term Relationships between price elasticity of demand

What will happen to total revenue if demand is elastic?

What will happen to total revenue if demand is inelastic?

What if demand is perfectly elastic, perfectly inelastic or of

▼ Table 2.2.1: Summary table for PED

Factors that influence PED

Percentage of income spent on the product

Necessities and luxuries?

Case study: The price of postcards

Income elasticity of demand

Cross elasticity of demand

This means that XED will be negative for complementary goods.

This section will develop your knowledge and understanding of:

Supply Key terms

Factors which determine the supply of a good

P Supply (S) P Supply (S)

▲ Figure 2.3.1: An extension of supply ▲ Figure 2.3.2: A contraction of supply

Weather and other events

Indirect taxes and subsidies

Movements along a supply curve and shifts

Shifts of the supply curve

▲ Figure 2.3.3: An increase in supply ▲ Figure 2.3.4: A decrease in supply

Case study: Problems hit Madagascar’s vanilla crop

This section will develop your knowledge and understanding of:

▲ Figure 2.4.1: Calculating PES

2. The percentage change in quantity supplied is greater than the

If supply is perfectly elastic, there could be any supply at a particular

▼ Table 2.4.1: Summary table for PES

• availability of stock 1 What were the answers for PES?

This section will develop your knowledge and understanding of:

How the interaction of demand and supply Link

Key terms Why excess demand and excess supply lead to

Case study: The market for strawberries

Use of demand and supply diagrams to analyse

Figure 2.5.6 shows what happens when there is an increase in supply.

Significance of different price elasticities of

▲ Figure 2.5.9: Significance of PES when demand

Key term Causes of fluctuations in commodity prices,

Commodities, such as oil or gold, are example of assets that often