Edexcel IAL Economics: Price determination, surplus, the price mechanism, indirect taxes and subsidies (YEC11)

This study guide covers section 1.3.4 Price determination, items 1 to 4, of the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (YEC11), Issue 2, June 2018. The specification labels Units 1 and 2 as International AS (IAS) and Units 3 and 4 as the extra International A2 (IA2) content. This is Unit 1, Markets in action, so it is IAS content and also part of the full IAL. Every number below is invented and illustrative.

Related pages: the Edexcel Economics hub, the printable checklist, the revision notes, the practice questions and the broader Markets in action guide. To find your weak spots first, try the free diagnostics.

What this section asks of you

Item	You must be able to	Where below
1a to 1c	Find equilibrium price and quantity, explain what shifts change it, and show how market forces remove excess demand or supply	Equilibrium
2a, 2b	Distinguish consumer and producer surplus and show how demand or supply changes affect them	Surplus
3a, 3b	Explain the rationing, incentive and signalling functions, in local, national and global markets	Price mechanism
4a to 4d	Analyse the impact and incidence of indirect taxes and of subsidies on consumers, producers and government	Taxes and subsidies

1. Equilibrium price and quantity

A market is in equilibrium when the quantity demanded equals the quantity supplied at the going price. There is no pressure on the price to change. On a diagram, the equilibrium is where the demand curve crosses the supply curve.

Our illustrative market is honey jars sold each week in Region A. Price P is in currency units (cu).

Demand: Qd = 900 - 50P        Supply: Qs = 50P - 100
Equilibrium: 900 - 50P = 50P - 100
             1,000 = 100P  ->  P = 10 cu
             Q = 900 - 500 = 400 jars   (check: 50 x 10 - 100 = 400)

Excess supply and excess demand (1c)

Excess supply means quantity supplied is greater than quantity demanded, which happens when price is above equilibrium. Excess demand means quantity demanded is greater, which happens when price is below equilibrium.

Price	Qd	Qs	Gap	Pressure
14 cu	200	600	excess supply of 400	price falls
10 cu	400	400	none	stable
6 cu	600	200	excess demand of 400	price rises

The adjustment chain at 14 cu runs like this. Unsold stock builds up. Sellers cut prices to clear it. As price falls, quantity demanded extends along the demand curve and quantity supplied contracts along the supply curve. The gap closes until 10 cu. At 6 cu the chain reverses. Queues and empty shelves let sellers raise prices, and buyers bid against each other. Quantity supplied extends and quantity demanded contracts until the shortage disappears.

Shifts and the new equilibrium (1b)

A shift of either curve moves the equilibrium. Keep the vocabulary exact: if only the good’s own price changes, you slide along a curve, but any other factor moves the whole curve.

Worked example, demand rises. A health trend adds 120 jars at every price, so Qd = 1,020 - 50P.

1,020 - 50P = 50P - 100  ->  1,120 = 100P  ->  P = 11.2 cu
Q = 50 x 11.2 - 100 = 460 jars

Price rises by 1.2 cu and quantity by 60 jars. Worked example, supply falls. A poor flowering season removes 100 jars at every price, so Qs = 50P - 200 (starting again from the original demand).

900 - 50P = 50P - 200  ->  1,100 = 100P  ->  P = 11 cu
Q = 900 - 550 = 350 jars

Price rises by 1 cu and quantity falls by 50 jars. A demand shift moves price and quantity in the same direction. A supply shift moves them in opposite directions. When both curves shift, the direction of one variable is certain and the other depends on which shift is larger.

2. Consumer and producer surplus

Consumer surplus is the gap between the most that buyers would pay for each unit and the price they really pay. On a diagram it is the area under the demand curve and above the price. Producer surplus is the difference between the price producers receive and the minimum price at which they would supply. It is the area above the supply curve and below the price. Use these words carefully: producer surplus is not profit, because the supply curve reflects marginal cost, not average cost.

With a straight-line curve, each surplus is the area of a triangle: half x base x height. Demand is P = 18 - Q/50, so the demand curve meets the price axis at 18 cu. Supply is P = 2 + Q/50, so the lowest supply price is 2 cu.

At P = 10, Q = 400:
Consumer surplus = 1/2 x (18 - 10) x 400 = 1,600 cu
Producer surplus = 1/2 x (10 - 2)  x 400 = 1,600 cu
Total surplus    = 3,200 cu

Effects of shifts (2b)

After the demand rise above, the price-axis intercept of demand becomes 1,020 / 50 = 20.4 cu, with P = 11.2 and Q = 460.

Consumer surplus = 1/2 x (20.4 - 11.2) x 460 = 2,116 cu   (up 516)
Producer surplus = 1/2 x (11.2 - 2)  x 460 = 2,116 cu   (up 516)

Both rise: the price is higher, but more units are traded, and consumers value the extra units highly. After the supply fall (P = 11, Q = 350, with the lowest supply price now 4 cu), consumers pay more and buy fewer jars, so consumer surplus is 1/2 x (18 - 11) x 350 = 1,225 cu, down 375. Producer surplus is 1/2 x (11 - 4) x 350 = 1,225 cu, also down 375. The general rules are:

• A rise in demand tends to raise both surpluses.
• A fall in supply raises price and shrinks consumer surplus. Producer surplus can rise or fall, depending on how much volume is lost.
• A rise in supply lowers price, raises quantity and enlarges consumer surplus.

3. The price mechanism

The price mechanism is the way prices adjust to match demand and supply and so allocate scarce resources. It has three functions (3a).

Function	What it does
Rationing	Limits scarce goods to those who are willing and able to pay the price. A higher price discourages marginal buyers.
Incentive	Higher prices and profits encourage producers to supply more and consumers to economise, while lower prices do the reverse.
Signalling	Price changes tell producers and consumers where resources are wanted. A rising price signals shortage or growing demand, a falling price signals surplus.

Chain for the honey market after the demand rise: price goes from 10 cu to 11.2 cu (signal), buyers who value a jar below 11.2 cu drop out (rationing), and beekeepers see higher margins and add hives (incentive). Output grows over time.

Local, national and global markets (3b)

The same three functions operate at every scale, but the speed and the mix of buyers differ.

• Local: a farmers’ market stall can change its chalkboard price in minutes. Rationing shows up as sell-outs, and signals are easy to read because buyers and sellers meet face to face.
• National: a rent rise in a growing city signals demand for homes. Builders respond, but planning delays and construction time slow the incentive effect.
• Global: a drought in a major exporting region raises the world price of a crop. High prices ration supply among importing countries, while farmers elsewhere are encouraged to plant more. The signal travels fast, but the response takes a whole growing season, and low-income buyers can be priced out entirely.

Evaluation: the mechanism works well when information is good and people respond to prices. It can fail when buyers cannot afford essentials, when supply responds slowly, or when prices ignore wider costs.

4. Indirect taxes and subsidies

An indirect tax is levied on spending. A specific tax adds the same cash amount to every unit sold, while an ad valorem tax adds a set percentage of the price. Legally the seller pays the government. Economically the burden is split between buyers and sellers. The split is the incidence.

On a diagram, a specific tax shifts the supply curve vertically upward by the amount of the tax, because at each quantity sellers need that much more to cover the tax. An ad valorem tax swings the curve upward by a growing amount at higher prices.

Worked example: tax with equal incidence (4a, 4b)

A tax of 5 cu per jar is added to the honey market, so Qs = 50(P - 5) - 100 = 50P - 350.

900 - 50P = 50P - 350  ->  1,250 = 100P  ->  P = 12.5 cu, Q = 275 jars
Consumers pay 12.5 cu: up 2.5 cu per jar.
Producers keep 12.5 - 5 = 7.5 cu: down 2.5 cu per jar.
Government revenue = 5 x 275 = 1,375 cu.
Consumer surplus = 1/2 x (18 - 12.5) x 275 = 756.25 cu
Producer surplus = 1/2 x (7.5 - 2)  x 275 = 756.25 cu
Welfare loss = 1/2 x 5 x (400 - 275) = 312.5 cu

Check: 756.25 + 756.25 + 1,375 = 2,887.5, and 3,200 - 2,887.5 = 312.5. The loss is the surplus on the 125 jars no longer traded.

Why incidence differs

Take a second illustrative market, Qd = 700 - 20P and Qs = 40P - 260. Equilibrium is P = 16 cu, Q = 380. Add a tax of 6 cu: Qs = 40P - 500.

700 - 20P = 40P - 500  ->  1,200 = 60P  ->  P = 20 cu, Q = 300
Consumers: 20 - 16 = 4 cu of the 6 cu tax (two thirds)
Producers: 16 - (20 - 6) = 2 cu of the 6 cu tax (one third)
Revenue = 6 x 300 = 1,800 cu

At equilibrium, price elasticity of demand is -20 x 16 / 380 = -0.84, and price elasticity of supply is 40 x 16 / 380 = 1.68. Demand is less elastic than supply, so consumers bear more. The rule: the less elastic side of the market carries more of the tax. The more elastic side can walk away more easily. Government raises most revenue from a good with inelastic demand, but this is harsh when the good is a necessity.

Impact on the three groups

• Consumers: pay a higher price and buy less. Their consumer surplus falls.
• Producers: sell fewer units at a lower net price, so revenue and producer surplus fall.
• Government: gains revenue but loses efficiency if the tax is not justified by a wider cost. Revenue depends on the quantity left after the tax, so a tax on a highly elastic good can raise little.

Subsidies (4c, 4d)

A subsidy is a per-unit payment from government to producers, so it shifts supply downward by the subsidy amount. Take a subsidy of 4 cu per jar in the first market: Qs = 50(P + 4) - 100 = 50P + 100.

900 - 50P = 50P + 100  ->  800 = 100P  ->  P = 8 cu, Q = 500 jars
Consumers pay 8 cu: down 2 cu. Producers receive 8 + 4 = 12 cu: up 2 cu.
Cost to government = 4 x 500 = 2,000 cu
Consumer surplus = 1/2 x (18 - 8) x 500 = 2,500 cu  (up 900)
Producer surplus = 1/2 x (12 - 2) x 500 = 2,500 cu  (up 900)
Net effect = 900 + 900 - 2,000 = -200 cu

The subsidy is shared in the same way as a tax: by elasticity. The net loss of 200 cu comes from the 100 extra jars whose cost exceeds their value. Evaluation asks what the government gets in return. If jars generated wider benefits, the subsidy might improve welfare overall. The opportunity cost of the 2,000 cu, and the risk of dependence on support, count against it.

Common errors

• Writing “supply increases” for a price rise. A price change moves you along the curve.
• Calling producer surplus profit.
• Drawing the tax as a shift of the demand curve.
• Giving tax incidence as 50:50 without checking elasticity.
• Forgetting that government revenue is the tax per unit x the new quantity.

Next: test yourself with the revision notes and the practice questions.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics (YEC11), Specification, Issue 2, June 2018, section 1.3.4 Price determination, items 1 to 4. Published by Pearson Education Limited.