Demand and supply in product markets, market equilibrium, consumer and producer surplus, and price, income and cross elasticities of demand and supply.

What this dot point is asking

WJEC wants you to use demand and supply to determine and shift equilibrium price and quantity, to identify consumer and producer surplus, and to calculate and interpret the main elasticities.

The answer

Demand, supply and equilibrium

The demand curve slopes downward because of the income and substitution effects and diminishing marginal utility; the supply curve slopes upward because higher prices cover rising marginal costs and attract producers. A change in price causes a movement along a curve. A change in a non-price determinant shifts the whole curve: demand shifts with income, the prices of substitutes and complements, tastes, population and expectations; supply shifts with costs of production, technology, taxes and subsidies, and the number of firms. Excess demand pushes price up; excess supply pushes price down; both pressures restore equilibrium.

Consumer and producer surplus

Together, consumer and producer surplus measure the total welfare generated by a competitive market, and they let you analyse who gains and loses from a price change, a tax or a subsidy. A tax that raises price reduces consumer surplus and shifts some of it to government revenue, with a deadweight welfare loss; a fall in price (for example from a rightward supply shift) raises consumer surplus.

The elasticities

PED is negative; demand is inelastic between 0 and -1 (raising price raises revenue) and elastic beyond -1 (raising price cuts revenue). Its determinants are the availability of substitutes, whether the good is a necessity or luxury, the proportion of income spent, and time. YED is positive for normal goods and negative for inferior goods, with luxuries having YED above 1. XED is positive for substitutes and negative for complements. PES is higher when firms have spare capacity, stocks, mobile resources and more time; it is low in the short run and higher in the long run.

Examples in context

Example 1. Tobacco, fuel and inelastic demand in UK tax policy. Goods such as tobacco, alcohol and petrol have price-inelastic demand because of habit, addiction, few substitutes and necessity. The UK government therefore taxes them heavily: an indirect tax raises price a lot but cuts quantity only a little, so it raises substantial revenue while reducing consumption modestly. The inelasticity is exactly why these are favoured tax bases and why "sin taxes" raise reliable revenue.

Example 2. Income elasticity and the changing UK consumer. As real incomes rise over the long run, demand shifts towards income-elastic luxuries (eating out, foreign holidays, premium goods) and away from inferior goods (some basic foods, intercity coach travel relative to rail or air). Firms and regions that produce income-elastic goods grow faster in booms but are hit hardest in recessions, which is why YED matters for both business strategy and for understanding the structure of the modern economy.

Try this

Q1. State the formula for the price elasticity of demand. [1 mark]

• Cue. PED equals the percentage change in quantity demanded divided by the percentage change in price.

Q2. Explain why a good with many close substitutes is likely to have price-elastic demand. [3 marks]

• Cue. If price rises, consumers can switch easily to substitutes, so quantity demanded falls more than proportionately, giving a PED value more negative than -1.