1The idea in one paragraph

Put the demand curve and the supply curve on the same axes and they cross once. At the price where they cross, the amount buyers want is exactly the amount sellers offer, and nobody is left disappointed. At every other price somebody is: either goods sit unsold, or buyers cannot get what they came for. That disappointment is not a resting state. It is a force. Unsold goods push the price down; unsatisfied buyers push it up; and the pushing only stops at the crossing point. Everything else in this subtopic is about what that price does on its way there, and about how much good the final arrangement does for everyone involved.

2Where the two curves cross

One market runs through this whole unit: refillable water bottles sold in a university town. Here is what buyers and sellers would do at each price in a week.

Read down the two middle columns. As the price falls, quantity demanded rises and quantity supplied falls, which is 2.1 and 2.2 side by side. The two columns meet at exactly one price, €12.

Market equilibrium is the price at which the quantity demanded equals the quantity supplied. That price is the equilibrium price, written P\, and the amount traded there is the equilibrium quantity, Q\. Another name for P\* is the market-clearing price, because at that price the market clears: every bottle offered finds a buyer and every buyer willing to pay €12 gets a bottle.

Figure 1 is the schedule drawn. Two things are worth saying about it plainly.

The equilibrium is a point, not an area. It is one price paired with one quantity, and the dotted lines that run from it to each axis are how you show which price and which quantity you mean. Leave them out and a marker cannot tell what you are claiming.

Nothing in the diagram forces the market to that point. What forces it there is what happens everywhere else, which is the next section.

3Every other price, and what it does about itself

Pick a price above €12, say €14. Sellers offer 480 bottles a week; buyers take 300. There are 180 bottles nobody wants at that price. That is excess supply, also called a surplus or a glut: quantity supplied exceeds quantity demanded.

Now pick a price below €12, say €10. Buyers want 500; sellers offer 320. There are 180 bottles' worth of buyers who leave with nothing. That is excess demand, also called a shortage: quantity demanded exceeds quantity supplied.

The gap in Figure 2 is the horizontal distance between the two curves at the price you are looking at. Not the vertical distance, and not a distance from the equilibrium. Read across from €14 to the demand curve and to the supply curve, and the distance between those two points is the excess supply. Paper 2 asks you to identify that gap far more often than it asks anything else about this diagram, so practise finding it.

Now the part students skip, and it is the part that carries the marks.

A shortage is not a condition a market is in. It is a pressure the market is under, and the pressure has an obvious outlet. At €10, four hundred buyers are chasing 320 bottles. Some of them offer more. Shops notice they sell out by Tuesday and raise the price on Wednesday. The price rises.

As it rises, two things happen at the same time, and both of them shrink the gap:

• Quantity demanded falls. Some buyers drop out as the price climbs. That is a movement up along the demand curve.
• Quantity supplied rises. The higher price makes bottles worth producing for firms that would not have bothered. That is a movement up along the supply curve.

The gap closes from both ends. At €11 it is only 90 bottles. At €12 it is nothing, and there is no longer any reason for the price to move. The market is back at equilibrium, and it got there by itself.

Excess supply works the same way in reverse. At €14 the stockroom fills up. Sellers cut prices to shift stock. As the price falls, quantity demanded rises along the demand curve and quantity supplied falls along the supply curve, and the 180 unsold bottles shrink to nothing at €12.

At the equilibrium price the quantity demanded equals the quantity supplied. At any other price the gap between them is exactly what pushes the price back.

Two warnings follow from this, and both are worth a mark each.

Neither curve moves during the adjustment. The price is changing, and the price is the good's own price, so every step of the adjustment is a movement along a curve. A student who draws a second demand curve while explaining how a shortage disappears has said something false about why it disappeared.

A shortage lasts only as long as something stops the price rising. Left alone, it is gone. When you read about a shortage that has lasted for years, look for the thing holding the price down — a maximum price set by a government, for instance, which you meet later in this unit.

4What the price is actually doing: signalling, incentive, rationing

Nobody in our university town decides how many bottles should be made. No committee counts students. The price does the work, and the guide asks you to separate the jobs it does.

Resource allocation is the overall job. Land, labour and capital are scarce, so putting them into bottles means not putting them into something else. The price mechanism decides that split, and it decides it through two effects.

Signalling. A price is information. When the price of bottles rises above €12, that rise tells every producer in the country that buyers want more bottles than are being made, and it tells every buyer that bottles have become scarcer relative to what people want. Nobody wrote the message and nobody sent it. The number itself is the message, which is why the price mechanism can co-ordinate millions of people who have never met.

Incentive. A signal that nobody acts on changes nothing. The same higher price also makes bottles more profitable to produce, so firms already in the market expand, and firms outside it enter. A lower price does the opposite: it tells firms to make less, and pays them less for making it, so some leave. Signalling and incentive are the same price change seen twice, once as information and once as a reward.

Rationing. At any one moment there is only so much of the good in existence. Something has to decide who gets it. In a market, price does: the bottles go to the buyers willing and able to pay what is being asked, and the rise in price is what clears the queue. Remove the price and you still have to ration somehow — by queueing, by lottery, by who you know — you have only chosen a different rationing device.

Put the three together and resources move out of markets where buyers value them less and into markets where buyers value them more. That is what economists mean when they say the price mechanism allocates resources.

Worth one sentence of evaluation, because part (b) rewards it: rationing by price rations by willingness and ability to pay, so a market can be efficient and still leave the poorest buyers with nothing. Efficiency and equity are different key concepts, and a market equilibrium promises only the first.

5Moving a curve: four changes, four new equilibria

Now let something change. In each case one curve shifts for one of the reasons you learned in 2.1 or 2.2, the other stays exactly where it was, and the market finds a new crossing point.

Suppose a hot summer raises the demand for bottles by 180 at every price. Do not jump to the answer. Walk it:

1. At the old price of €12, quantity demanded is now 580 while quantity supplied is still 400.
2. That is excess demand of 180 bottles.
3. The shortage pushes the price up. Quantity demanded falls back along the new demand curve; quantity supplied rises along the unchanged supply curve.
4. The gap closes at €14, where 480 bottles are traded.

Step 2 is the step candidates leave out, and it is the step the syllabus names. Saying "demand rose so price rose" describes the two ends; saying "at the old price there was excess demand of 180, which bid the price up" explains the middle, and the middle is where the marks are.

The other three cases work the same way, and each also opens with a gap of 180 at €12.

Read the last two columns together and a pattern appears that is worth memorising. A shift in demand moves price and quantity the same way. A shift in supply moves them opposite ways.

That pattern has a sharp edge, and Paper 2 uses it. Look at the two rows where the price ends at €14. A rise in demand and a fall in supply produce the same new price. The price on its own cannot tell you which curve moved. Only the quantity separates them: demand rising takes quantity up to 480, supply falling takes it down to 300. So when a data extract tells you the price of something has gone up, do not guess the cause. Find which determinant the extract actually mentions, decide from that whether it belongs to demand or to supply, and let the quantity follow.

Two more things markers watch for. Move one curve per diagram unless the question genuinely gives you two changes. And read the new equilibrium off the new crossing point, never off the end of the shift arrow: the arrow shows which way the curve went, not where the market ended up.

6Consumer surplus and producer surplus

Everyone in our market pays or receives €12. Almost nobody valued the bottle at exactly €12, and that difference is where the gains from trading come from.

Think about what the demand curve is telling you, unit by unit. Its height above any quantity is the most that somebody would pay for that bottle. The first bottle of the week goes to someone who would have gone up to €20. She pays €12. She is €8 better off than if she had not traded, and that €8 is hers to keep.

Consumer surplus is the difference between what consumers are willing to pay for a good and what they actually pay. On the diagram it is the area below the demand curve and above the price, out to the quantity traded.

The supply curve tells the mirror story. Its height above any quantity is the lowest price a producer would accept for that bottle, because it is what that bottle costs to bring to market. The first bottle costs only €2 to produce; its maker receives €12, and pockets €10.

Producer surplus is the difference between the price producers receive and the lowest price they would have been willing to accept. On the diagram it is the area above the supply curve and below the price, out to the quantity traded.

Both areas are measured from the price line. Consumers count downwards from their demand curve to the price; producers count upwards from the price to their supply curve. Shade from the wrong place — from the quantity axis, say — and you have drawn total spending, not surplus, which is the error in section 10.

7Social surplus, and why the equilibrium is where it is biggest

Add the two together and you have the gain the whole market produces.

Social surplus, also called community surplus, is consumer surplus plus producer surplus. It is the total benefit society gets from this market: the whole area between the demand curve and the supply curve, up to the quantity traded.

The claim the syllabus wants you to be able to defend is that this total is at its largest at the competitive market equilibrium. The way to defend it is to try to beat it and fail.

Trade too little. Suppose only 200 bottles are made. The 200th bottle is worth €16 to the person who gets it, and it cost €7 to produce. Every bottle between 200 and 400 is worth more to a buyer than it costs a seller, so each one of them is a gain that is simply not being made. The clay triangle in the left panel of Figure 7 is that lost gain: surplus that could have existed and does not.

Trade too much. Suppose 600 are made. The 600th bottle is worth €8 to the buyer who ends up with it, but it used up €17 of society's scarce resources. Making it destroys €9 of value. Every bottle past 400 does something similar, and the clay triangle in the right panel is the damage.

Only at 400 is there neither a gain left on the table nor a bottle being made that is not worth making. Any move away from Q\* in either direction shrinks social surplus, which is what "maximised at the competitive market equilibrium" means. (That clay triangle has a name, welfare loss, and you meet it properly when price controls and externalities push markets off their equilibrium later in this unit.)

8Allocative efficiency: MB = MC

Section 7 in one line, using the language the exam wants.

Marginal benefit (MB) is the extra benefit to consumers from one more unit of the good. That is exactly what the height of the demand curve measures, so the demand curve is the marginal benefit curve. Marginal cost (MC) is the extra cost to producers of one more unit, which is what the height of the supply curve measures, so the supply curve is the marginal cost curve.

Allocative efficiency is reached when resources are allocated so that social surplus is maximised — where the marginal benefit of the last unit produced equals its marginal cost.

The logic runs in three steps, and writing all three earns the marks:

• Where MB > MC, as at 200 bottles, the next bottle is worth more than it costs, so society gains by making it. Make more.
• Where MC > MB, as at 600 bottles, the next bottle costs more than it is worth, so society loses by making it. Make fewer.
• The only quantity where neither is true is where MB = MC, and that is where the two curves cross — the competitive market equilibrium.

So a competitive market left alone reaches allocative efficiency without anyone aiming at it. Exactly the right share of society's scarce resources goes into bottles: no bottle is missing that was worth making, and no bottle was made that was not.

Hold two limits in mind for part (b), because a flat claim that markets are efficient is an easy answer to attack. This result assumes the market really is competitive, and that the demand curve captures all the benefit and the supply curve all the cost. When one firm has power over price, or when production harms a third party, MB and MC as drawn here stop telling the truth, and the equilibrium stops being efficient. You meet both cases later in this unit.