How prices are determined
What's covered
Key facts
Demand for goods and services
Demand is the willingness and ability of consumers to buy a quantity of a good or service; effective demand is a want or need supported by an ability to pay.
Equilibrium price
Excess demand typically happens when the price is set below its equilibrium level, while a price set too high relative to demand causes excess supply.
Intermarket relationships
A fall in the price of one good expands quantity demanded of it and can raise demand for its complement.
Price elasticity of demand
Demand is price elastic when quantity demanded is highly responsive to a change in price, with a PED coefficient greater than 1 (ignoring the sign).
Price elasticity of supply
Supply is price elastic (responsive to price changes) when PES is greater than 1 and price inelastic when PES is less than 1.
Supply for goods and services
The supply curve slopes upwards because higher prices give producers an incentive to supply more and make it feasible to cover the higher costs of extra output.
Demand for goods and services
Demand for a normal good rises as income rises, while demand for an inferior good (for example instant noodles or store-brand products) falls as income rises.
Equilibrium price
A decrease in demand shifts the demand curve left, giving a new equilibrium price and quantity that are both lower than the original.
Intermarket relationships
Complementary goods are products that are bought and used together, such as fish and chips or smartphones and apps.
Price elasticity of demand
Goods taking a larger proportion of income are more price elastic: PED for a daily newspaper is likely to be much lower than for a new car.
Practice questions with answers
A taste of the 69 questions in this topic, answers marked. Sign up to practise the full set with spaced repetition.
A fall in the price of trainers means more pairs are bought. How is this shown on a demand diagram?
- ✓A movement along the demand curve
- •A movement along the supply curve
- •A shift of the demand curve to the right
- •A shift of the supply curve to the right
What is true at the equilibrium price in a market?
- •Consumers pay the lowest possible price
- •Producers earn the highest possible profit
- ✓Quantity demanded equals quantity supplied
- •Quantity demanded exceeds quantity supplied
Which pair of products are complements?
- •Buses and trains
- •Butter and margarine
- ✓Fish and chips
- •Tea and coffee
A brand of jeans has a PED of -0.5. What does this value tell you?
- •Demand is perfectly inelastic
- •Demand is price elastic
- ✓Demand is price inelastic
- •Demand is unit elastic
A firm's PES is 0.4. How would an economist describe this?
- •Supply is perfectly elastic
- •Supply is price elastic
- ✓Supply is price inelastic
- •Supply is unit elastic
Which of these would shift the supply curve for bread to the left?
- •A fall in the price of bread
- •A government subsidy to bakers
- ✓A rise in the price of wheat
- •New bread-making machinery
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