Price Determination

• What is the equilibrium price and quantity?

  When supply meets demand

  
• How is equilibrium shown on a diagram?

  By P1 and Q1

  
• What happens at market equilibrium?

  Price has no tendency to change
• What is another name for the market equilibrium price?

  Market clearing price
• What occurs at Q2 when price is at P2?

  Demand is greater than supply
• How can excess demand be calculated?

  By Q3 - Q2
• What does it mean when demand price does not equal supply price?

  It indicates a state of disequilibrium
• What is a shortage in the market?

  When demand exceeds supply
• What happens when prices increase due to excess demand?

  Firms supply more
• What occurs when supply meets demand again?

  Price reaches the market clearing price, P1
• What is excess supply?

  When price is above P1
• What happens when supply is at Q2 and demand is at Q1?

  There is a surplus of Q2 - Q1

  
• What do firms do when there is excess supply?

  They lower their prices
• What happens to the market when prices fall due to excess supply?

  The market will clear and return to equilibrium
• What causes new market equilibriums to be established?

  • Shifts in demand or supply curves
  • Influenced by PIRATES or PINTSWC reasons
• What happens if there is an increase in the size of the population?

  Demand shifts from D1 to D2
• What is the result of increased demand due to population growth?

  Price increases to P2
• What happens to the quantity supplied when demand increases?

  Suppliers supply a larger quantity of Q2
• Where is the new market equilibrium established after increased demand?

  At P2 Q2
• At what point are consumer and producer surplus maximized?

  At the free market equilibrium
• What is consumer surplus?

  The difference between willingness to pay and actual price
• What influences consumer surplus?

  Perceived private benefit from consuming the good
• What area represents consumer surplus on a graph?

  Area above market price and below demand curve

  
• How does the law of diminishing marginal utility affect consumer surplus?

  It generally declines with extra units consumed
• Why do inelastic demand curves result in larger consumer surplus?

  Consumers are willing to pay higher prices
• How does an increase in demand affect consumer surplus?

  • Increases consumer surplus from PQR to ABC
  • Shifts demand curve from D1 to D2
• What happens to consumer surplus when supply shifts left?

  • Consumer surplus decreases from PQR to ABR
  • Caused by higher production costs
• What is producer surplus?

  The difference between price willing to charge and actual price
• Where is producer surplus located on a graph?

  Area below market price and above supply curve

  
• How does a shift in the supply curve affect producer surplus?

  • Increases producer surplus from ABC to PQS
  • Caused by lower average production costs
• How can an increase in demand affect producer surplus?

  • Increases producer surplus from area PQD to ABD
  • Causes market price to increase
• What is economic welfare?

  Total benefit society receives from an economic transaction
• How is economic welfare calculated?

  By adding producer surplus and consumer surplus
• Why is economic welfare important?

  It helps assess effects of government policies
• What determines the market price in a free market economy?

  The price mechanism
• Who referred to the price mechanism as ‘the invisible hand of the market’?

  Adam Smith
• How are resources allocated in a free market economy?

  Through the price mechanism
• What economic problem does the price mechanism solve?

  The problem of scarce resources
• How does the price mechanism respond to a surplus of resources?

  It removes resources from where there is a surplus
• What happens to prices when there is excess demand for a resource?

  Prices increase