Demand and supply, the determinants and elasticities (PED, YED, XED, PES), the price mechanism and its functions, consumer and producer surplus, and the basics of consumer behaviour.

What this dot point is asking

Edexcel wants you to explain what shifts demand and supply, calculate and interpret the four elasticities, explain how the price mechanism allocates resources through rationing, signalling and incentives, and define consumer and producer surplus. This is the analytical toolkit for the whole of microeconomics, so accuracy on diagrams and elasticity calculations here pays off across Themes 1 and 3.

The answer

Demand, supply and equilibrium

Demand slopes down because of the income and substitution effects and diminishing marginal utility. Non-price shifters (remembered as PIRATES or similar) include income, the price of substitutes and complements, tastes, population and expectations. Supply slopes up because higher prices cover rising marginal costs; it shifts with costs of production, technology, indirect taxes, subsidies, weather and the number of firms.

Equilibrium is where demand equals supply. Excess demand (a shortage) pushes price up; excess supply (a surplus) pushes it down, until the market clears. A shift in either curve moves the equilibrium; a change in the good's own price is a movement along the curve, not a shift.

The four elasticities

• PED depends on substitutes, the proportion of income spent, whether the good is a necessity, and time. It links to total revenue: if demand is inelastic, raising price raises revenue.
• YED $= \dfrac{\%\Delta\ \text{quantity demanded}}{\%\Delta\ \text{income}}$. Positive for normal goods, above $1$ for luxuries, negative for inferior goods.
• XED $= \dfrac{\%\Delta\ \text{quantity demanded of A}}{\%\Delta\ \text{price of B}}$. Positive for substitutes, negative for complements.
• PES $= \dfrac{\%\Delta\ \text{quantity supplied}}{\%\Delta\ \text{price}}$. Higher when firms have spare capacity, stocks, mobile factors and more time.

The price mechanism

Consumer and producer surplus

Consumer surplus is the area between the demand curve and the price, capturing the extra value buyers gain above what they pay. Producer surplus is the area between the price and the supply curve, the gain to firms above the minimum they would accept. Together they measure the welfare a market generates, and policy is often judged by its effect on the sum of the two.

Examples in context

When the 2022 energy price shock raised gas prices sharply, household gas demand fell only a little because demand is inelastic in the short run, so spending on energy rose, a clear PED-to-revenue link. The cost-of-living squeeze pushed some consumers toward supermarket own-brand ranges, an income effect consistent with negative YED for inferior goods. House prices rationed scarce housing to higher bidders (rationing function) while signalling builders to construct more (signalling and incentive functions), illustrating the price mechanism at work.

Try this

Q1. Define price elasticity of demand and explain one factor that makes demand more elastic. [4 marks]

• Cue. Responsiveness of quantity demanded to price; more close substitutes makes demand more elastic.

Q2. Examine how the price mechanism allocates resources following a poor harvest. [10 marks]

• Cue. Lower supply raises price, which rations the scarce crop, signals scarcity and gives an incentive to plant more next season.