Explain the operation of the market mechanism including the laws of demand and supply, equilibrium price and quantity, movements along and shifts of curves, and price elasticity of demand and supply

What this dot point is asking

QCAA wants you to explain how markets allocate resources through demand and supply, draw and interpret market diagrams, distinguish movements along from shifts of the curves, find equilibrium, and apply the elasticity concept. Expect a stimulus-based response in IA1 or the EA.

The answer

The law of demand

The law of demand states that, holding other factors constant, the quantity demanded of a good rises when the price falls (and vice versa). The demand curve slopes downward.

Three reasons:

1. Substitution effect. Higher price for X leads consumers to switch to substitutes.
2. Income effect. Higher price for X reduces real purchasing power, so consumers buy less of all normal goods.
3. Diminishing marginal utility. Each extra unit consumed gives less satisfaction, so consumers will only buy more units at a lower price.

Non-price determinants of demand

Demand shifts (rather than moves along) when one of these factors changes:

• Income. Higher income shifts demand right for normal goods, left for inferior goods.
• Price of substitutes. Higher substitute price shifts demand right.
• Price of complements. Higher complement price shifts demand left.
• Population. Larger population shifts demand right.
• Tastes and preferences. Cultural shifts, advertising.
• Expectations. Expected future price rises shift current demand right.

The law of supply

The law of supply states that, holding other factors constant, the quantity supplied rises when the price rises. The supply curve slopes upward.

Three reasons:

1. Rising marginal cost. Firms face diminishing returns and rising marginal cost as they expand.
2. Profit incentive. Higher prices make production more profitable.
3. Entry by new firms. High prices attract new entrants.

Non-price determinants of supply

Supply shifts when:

• Input costs. Lower wages, energy, materials shift supply right.
• Technology. Productivity-enhancing technology shifts supply right.
• Number of firms. New entry shifts supply right.
• Government policy. Subsidies shift supply right; taxes and regulation shift supply left.
• Weather and natural events. Affect agricultural supply.

Equilibrium

Equilibrium is the price and quantity where demand equals supply. Diagrammatically, equilibrium is the intersection of the demand and supply curves.

At any other price:

• Price above equilibrium. Quantity supplied exceeds quantity demanded: surplus. Sellers cut prices.
• Price below equilibrium. Quantity demanded exceeds quantity supplied: shortage. Buyers bid prices up.

Market forces drive the price back to equilibrium.

Movements along vs shifts

Movement along a curve happens when the price of the good itself changes. The other factors are held constant.

Shift of a curve happens when a non-price determinant changes. The whole curve moves; quantity demanded or supplied changes at every price.

Markers reward responses that explicitly distinguish these.

Worked example: the iron ore market

Initial position

Iron ore at $80 per tonne; Australia exports around 900 million tonnes per year.

Demand shift right

Chinese stimulus spending raises construction activity, increasing demand for steel and therefore iron ore. The demand curve shifts right.

New equilibrium

Price rises to $130; quantity rises slightly (supply is relatively inelastic in the short run because mine capacity is fixed).

Supply shift right (separate scenario)

Discovery of new deposits and capacity expansion at major Pilbara mines (Rio Tinto, BHP, Fortescue) shifts the supply curve right. Price falls; quantity rises.

Price elasticity of demand

Price elasticity of demand (PED) measures the responsiveness of quantity demanded to a change in price.

Conventionally expressed as the absolute value.

Interpretation:

• PED > 1: elastic. Quantity is highly responsive to price. Consumers switch to substitutes readily. Examples: branded products with close competitors.
• PED = 1: unit elastic. Total revenue does not change with price.
• PED < 1: inelastic. Quantity is unresponsive to price. Examples: necessities like petrol in the short run, prescription medicines.
• PED = 0: perfectly inelastic. Vertical demand curve. Examples: life-saving drugs at any reasonable price.
• PED = infinity: perfectly elastic. Horizontal demand curve. Examples: a single firm in perfect competition.

Determinants of PED

• Number of substitutes. More substitutes → more elastic.
• Necessity vs luxury. Luxuries are more elastic.
• Proportion of income spent. A larger share of income → more elastic.
• Time horizon. Demand becomes more elastic over time as consumers adjust (the short-run petrol demand is inelastic; the long-run is more elastic as consumers buy more fuel-efficient cars).
• Definition of the market. Narrower markets (Coca-Cola) are more elastic than broader markets (all soft drinks, which are more elastic than all beverages).

Price elasticity of supply

Price elasticity of supply (PES) measures the responsiveness of quantity supplied to a change in price.

Determinants:

• Time horizon. Supply is more elastic over time as firms can vary capacity.
• Mobility of factors. If labour and capital can shift easily between industries, supply is more elastic.
• Capacity utilisation. If firms are operating below capacity, supply is more elastic.
• Storability. Goods that can be stored have more elastic supply.

Applications of elasticity

Tax incidence

When demand is inelastic and supply is elastic, the consumer bears most of the tax burden (e.g. cigarettes). When demand is elastic and supply is inelastic, the producer bears most (e.g. fresh produce).

Pricing strategy

Firms with inelastic demand can raise prices to increase total revenue. Firms with elastic demand should be cautious about raising prices.

Agricultural policy

Agricultural demand and supply are both relatively inelastic. Bumper harvests can sharply lower prices and farm income; crop failures sharply raise them. Stabilisation policies (price floors, marketing boards) address this volatility.

Currency markets

Australia's exports of iron ore have relatively inelastic supply in the short run (mines cannot expand quickly) but elastic supply in the long run (new mines can be developed).

Common QCE traps

Confusing movement along with shift

A change in the good's own price moves along the curve. A change in any other determinant shifts the curve.

Drawing both curves shifting when only one should

Identify which factor changed and which curve it affects.

Calculating elasticity without the absolute value

PED is conventionally reported as a positive number, even though the underlying ratio is negative.

Treating elasticity as constant along a curve

Linear demand curves have varying elasticity at different points; elasticity is high near the vertical intercept and low near the horizontal intercept.