Equilibrium, the price mechanism and consumer and producer surplus

Last time

Before we start: last time, in Income, cross and supply elasticities, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

Where markets settle

Markets move towards the price where demand equals supply. The price mechanism does three jobs in getting there. And at equilibrium, consumers and producers both gain something extra: consumer and producer surplus.

Equilibrium

Demand and supply cross at E: an equilibrium price of 5 dollars and quantity of 5. Above it, excess supply pushes the price down; below it, excess demand pushes it up.

Changes in equilibrium

An increase in demand raises equilibrium price and quantity. A decrease lowers both. An increase in supply lowers price and raises quantity. A decrease raises price and lowers quantity. When both curves shift, the effect on one variable is certain and the other depends on the size of the shifts.

Restricting supply

If producers restrict supply, such as small pomegranate growers agreeing to sell less, supply shifts left. The price rises. Whether their revenue rises depends on price elasticity of demand: if demand is inelastic, revenue rises. But higher prices may attract new suppliers, or consumers may switch to substitutes in the long run.

The functions of the price mechanism

Signalling: price changes tell producers and consumers about changes in scarcity. Incentive: higher prices encourage firms to produce more, and consumers to economise. Rationing: price allocates scarce goods to those willing and able to pay.

Does price always prevent over-consumption?

Rationing by price limits consumption of scarce goods. But for demerit goods, the price ignores external costs and information failure, so over-consumption continues. And where demand is price inelastic, a higher price reduces consumption only a little.

Consumer surplus

Consumer surplus is the difference between what consumers are willing to pay and what they actually pay. On the diagram, it is the area below the demand curve and above the price: here a triangle of half times 5 times 5, which is 12.5. A fall in price increases consumer surplus.

Producer surplus

Producer surplus is the difference between the price producers receive and the minimum they would accept. On the diagram, it is the area above the supply curve and below the price: here also 12.5. A fall in price usually reduces producer surplus, but if supply rises, more is sold, so it may not fall.

Mistakes that lose marks

Mistake one: calling consumer surplus the money consumers save in a sale. Mistake two: saying both curves shifting has a certain effect on price and quantity. Mistake three: listing the functions of price without explaining how each works. The fix: area-based definitions, and explained functions.

The full-marks tip

The full-marks tip: define surplus as an area on the diagram, and shade it when you draw it. For changes in equilibrium, say which curve shifts, and the new price and quantity.

On one card

So, on one card: equilibrium and surplus. Keep it for revision.