What is the underlying assumption of rational economic decision-making regarding consumers?

Consumers aim to maximise utility which is the satisfaction they earn from the consumption of goods and services.

What is the underlying assumption of rational economic decision-making regarding producers?

It is assumed that producers aim to maximise profits in order to satisfy shareholders.

What is the distinction between movements along a demand curve and shifts of a demand curve?

To understand the distinction between movements along and shifts of a demand curve, it is first important to understand the concept of demand. Demand is defined as the ability and willingness to purchase a certain good or service at a given price within a certain period of time. According to the law of demand, there is an inverse relationship between the price of a good or service and the quantity demanded of this good or service.

A movement along a demand curve is where a price change will lead to a change in the quantity demanded. This can be shown using a diagram.

In the above diagram, a fall in the price from P to P1 has caused a movement along the demand curve and an extension in quantity demanded from Q to Q1.

In the above diagram, an increase in price from P to P1 has resulted in a movement along the demand curve and a contraction in quantity demanded from Q to Q1.

A shift of the demand curve occurs when there is a complete movement of the entire demand curve inwards or outwards. A shift of the demand curve comes about as a result of a change in one of the factors that influences demand. This can be shown using a diagram.

In the above diagram, an increase in demand has led to an outward shift of the demand curve from D to D1. At a price of P, before the outward shift of the demand curve, there was a quantity demanded of Q, but following the outward shift of the demand curve, the quantity demanded has risen to Q1.

In the above diagram, a fall in demand has led to an inward shift of the demand curve from D to D1. At a price of P, before the inward shift of the demand curve, there was a quantity demanded of Q, but following the inward shift of demand, the quantity demanded has fallen to Q1

What are the factors that may cause a shift in the demand curve (the conditions of demand)?

1. Changes in income. When incomes rise, for normal goods and services, there is likely to be an increase in demand and hence an outward shift of the demand curve as consumers will spend the money they receive from higher incomes on these normal goods and services. A fall in incomes will lead to a fall in demand and an inward shift of the demand curve for normal goods and services. For inferior goods and services, a rise in incomes will lead to a fall in demand and an inward shift of the demand curve, and a fall in incomes will lead to a rise in demand and an outward shift of the demand curve for these inferior goods and services. The concept of inferior and normal goods and services is linked to the concept of income elasticity of demand. This is discussed later in this article.
2. Changes in consumer tastes and preferences. Consumer preferences are often influenced by the latest trends in society. If a good or service becomes more trendy, it is likely that consumers will want to buy more of this product, leading to an increase in demand and an outward shift of the demand curve for this good or service. Conversely, if a good or service becomes less trendy or fashionable, demand will fall for this good or service, resulting in an inward shift of the demand curve.
3. Changes in advertising. An increase in the level of advertising of a firm's goods and services will likely result in an increase in demand and an outward shift of the demand curve for this firm's goods and services as consumers are likely to be persuaded to purchase this firm's goods and services if the advertising is effective. Conversely, not much advertising by a firm and large amounts of advertising by this firm's competitors will likely result in a fall in demand and an inward shift of the demand curve for the goods and services of the firm that doesn't advertise
4. Changes in the price of related goods and services. A substitute is a good or service that acts as a similar alternative to another good or service. An increase in the price of a substitute compared to a related good or service (for example an increase in the price of tea relative to the price of coffee as tea is a substitute for coffee) is likely to lead to an increase in demand and an outward shift of the demand curve for the related good or service as the substitute is now more expensive (in the example above, an increase in the price of tea will result in more demand and an outward shift of the demand curve for coffee as coffee may now be relatively cheaper than tea). A fall in the price of a substitute will hence likely lead to a fall in demand and an inward shift of the demand curve for the related good or service (for example, a fall in the price of tea will result in less demand and an inward shift of the demand curve for coffee). A complement is a good or service that is often used in conjunction with another good or service. An increase in the price of a complement compared to a related good or service (for example, an increase in the price of printer ink cartridges in comparison with the price of printers) will likely result in a fall in demand and an inward shift of the demand curve for the related good or service as the complement to the good or service, that is often required to be bought in order to use the related good or service, is now more expensive (in the example above, an increase in the price of printer ink cartridges will lead to a fall in demand and an inward shift of the demand curve for printers, as the printer ink cartridges that are required in order to use a printer are now more expensive). A fall in the price of a complement will result in an increase in demand and an outward shift of the demand curve for the related good or service, as the complement which is often required to be used alongside the related good or service is now cheaper (for example, a fall in the price of printer ink cartridges will lead to an increase in demand and an outward shift of the demand curve for printers).

What is the concept of diminishing marginal utility and how does it influence the shape of the demand curve?

Diminishing marginal utility is a principle which depicts that less additional utility (satisfaction) is gained from the consumption of an additional good or service, the more of the good or service is consumed.

The concept of diminishing marginal utility influences the shape of the demand curve. This is because, when the price of a good or service is high, the consumer is unlikely to purchase large quantities of the good or service, as the additional utility they gain from additional units is likely to be lower than the price, resulting in the consumer only buying small quantities. Whereas, when the price of a good or service is low, the additional utility the consumer gains from additional units is likely to be higher than the price, resulting in the consumer buying more units.

What is meant by price, income and cross elasticities of demand?

Price Elasticity of Demand (PED) is a measure of the responsiveness of the quantity demanded of a good or service when there is a change in the price of the good or service.

Income Elasticity of Demand (YED) is a measure of the responsiveness of the quantity demanded of a good or service when there is a change in real incomes.

Cross Elasticity of Demand (XED) is a measure of the responsiveness of the quantity demanded of a good or service to a change in the price of another good or service.

How can formulae be used to calculate price, income and cross elasticities of demand?

Price Elasticity of Demand (PED) = (% change in quantity demanded) / (% change in price).

Income Elasticity of Demand (YED) = (% change in quantity demanded) / (% change in real incomes).

Cross Elasticity of Demand (XED) = (% change in quantity demanded of good X) / (% change in price of good Y).

How can numerical values of price elasticity of demand be interpreted (unitary elastic, perfectly and relatively elastic, and perfectly and relatively inelastic)?

Unitary price elasticity of demand (price elasticity of demand: -1) occurs where a change in price results in a proportionate change in quantity demanded.

Perfectly elastic price elasticity of demand (price elasticity of demand: -∞) occurs where a change in price results in an infinite change in quantity demanded.

Relatively elastic price elasticity of demand (price elasticity of demand: -∞ < price elasticity of demand < -1) occurs where a change in price results in a more than proportionate change in quantity demanded.

Perfectly inelastic price elasticity of demand (price elasticity of demand: 0) occurs where a change in the price results in no change in quantity demanded.

Relatively inelastic price elasticity of demand (price elasticity of demand: -1 < price elasticity of demand < 0) occurs where a change in price results in a less than proportionate change in quantity demanded.

How can numerical values of income elasticity of demand be interpreted (inferior, normal and luxury goods including relatively elastic and relatively inelastic)?

An inferior good (income elasticity of demand < 0) is a good where as real incomes rise, there is a fall in quantity demanded. As real incomes fall, for inferior goods, there is an increase in the quantity demanded.

A normal good (income elasticity of demand > 0) is a good where as real incomes rise, there is an increase in quantity demanded. For normal goods, when real incomes fall, this will likely result in a fall in the quantity demanded.

A luxury good (income elasticity of demand > 1) is a good where as real incomes rise, there is a more than proportionate increase in quantity demanded. As real incomes fall, for luxury goods, there is a more than proportionate fall in quantity demanded.

A good that is income relatively elastic has an income elasticity of demand value that is between -∞ and -1 or between 1 and ∞.

A good that is income relatively inelastic has an income elasticity of demand value that is between -1 and 0 or between 0 and 1.

How can numerical values of cross elasticity of demand be interpreted (substitute, complementary and unrelated goods)?

Substitute goods (cross elasticity of demand > 0) are goods where an increase in the price of one of the goods will likely result in an increase in the quantity demanded of the other good. A fall in the price of one of the goods will likely result in a fall in the quantity demanded of the other good.

Complements (cross elasticity of demand < 0) are goods where an increase in the price of one of the goods will likely lead to a fall in the quantity demanded of the other good. A fall in the price of one of the goods will likely lead to an increase in the quantity demanded of the other good.

Unrelated goods (cross elasticity of demand = 0) are goods where a change in the price of one good will have no effect on the quantity demanded of the other good.

What factors influence elasticities of demand?

1. How addictive a good or service is. The more addictive a good or service is, the more likely it is that demand will be inelastic as consumers don't pay as much attention to the price of a good or service when they are addicted to a good or service. When a good isn't so addictive, demand is likely to be more elastic.
2. Time period. In the long run, demand tends to be more elastic as alternatives can be found more easily in the long run compared to the short run where demand is likely to be more inelastic.
3. Proportion of income. If a good or service takes up a large proportion of income, it is likely that demand will be more elastic for this good or service. This is because, even if the price of a good or service that takes up a large proportion of income rises by a few percentage points, this is likely to have a large impact on the quantity that an individual can buy, making demand more elastic. A good or service that takes up a lower proportion of income is likely to have more inelastic demand.
4. How substitutable a good or service is. If lots of substitutes exist, then it is likely that an increase in price will result in a more than proportionate fall in quantity demanded as consumers purchase relatively cheaper substitutes. Hence, if a good or service is easily substitutable, demand for the good or service will likely be elastic, and if it isn't easily substitutable, demand for the good or service will likely be inelastic.

What is the significance of elasticities of demand to firms and government regarding the imposition of indirect taxes and subsidies?

The imposition of an indirect tax is likely to result in an increase in the price of a good or service that a firm sells. If demand is relatively price elastic, an increase in the price due to the indirect tax will likely result in a more than proportionate contraction in quantity demanded for the goods or services that a firm produces. If demand is relatively price inelastic, an increase in the price due to the indirect tax will likely result in a less than proportionate contraction in quantity demanded for the goods or services that a firm produces. Hence, if a government wants to reduce the quantity of a good or service in an economy, an indirect tax on a good or service which has a more elastic price elasticity of demand will be more effective than the same indirect tax on a good which has a more inelastic price elasticity of demand.

A subsidy is likely to lead to a reduction in the price of a good or service that a firm sells. A fall in the price (due to a subsidy) of a good or service that has a relatively elastic price elasticity of demand is likely to result in a more than proportionate extension in quantity demanded for firms that sell this good or service. A fall in the price of a good or service that has a relatively inelastic price elasticity of demand is likely to result in a less than proportionate extension in quantity demanded for firms. Hence, if a government wants to boost the quantity of a good or service in an economy, this is more easily achieved when subsidising goods that have a more elastic price elasticity of demand.

What is the significance of elasticities of demand to firms and government regarding changes in real income?

The effect on firms of changes in real income will depend on the income elasticity demand for the firm's goods or services. For normal goods and services, an increase in real incomes will result in an increase in quantity demanded, and for an inferior good or service, a rise in real incomes will result in a fall in quantity demanded for firms. This will affect the amount of government tax revenue received from indirect taxes on these goods and services.

What is the significance of elasticities of demand to firms and government regarding changes in the price of substitute and complementary goods?

The demand for a firm's goods or services will depend on the cross elasticity of demand for the firm's goods or services. If the good or service that the firm produces has a cross elasticity of demand of more than 0, this symbolises that an increase in the price of a substitute will lead to an increase in the quantity demanded of the good or service that this firm produces. However, if the good or service that a firm produces has a cross elasticity of demand of less than 0, this symbolises that an increase in the price of a complement will result in a fall in the quantity demanded of the good or service that this firm produces. These relationships will affect the amount of government tax revenue received from indirect taxes on these goods and services.

What is the relationship between price elasticity of demand and total revenue (including calculation)?

When demand is relatively price inelastic, an increase in the price of a good or service will likely result in an increase in total revenue, as the contraction in quantity demanded is less than proportionate to the increase in price. When demand is relatively price inelastic, a fall in the price of a good or service will likely result in a fall in total revenue, as the extension in quantity demanded is less than proportionate to the fall in price. 

When demand is relatively price elastic, an increase in the price of a good or service will likely result in a fall in total revenue, as the contraction in quantity demanded is more than proportionate to the increase in price. When demand is relatively price elastic, a fall in the price of a good or service will likely result in an increase in total revenue, as the extension in quantity demanded is more than proportionate to the fall in price. 

When price elasticity of demand is unitary, any change in price will have no effect on total revenue as a change in price will have a proportionate effect on quantity demanded.

A calculation can be used to show the relationship between price elasticity of demand and total revenue.

For example, a firm sells a good at a price of £2 at a quantity demanded of 10 with PED = -10. The price of the good falls to £1. The change in price from £2 to £1 is -50%. PED = (% change in quantity demanded) / (% change in price), this can be rearranged to (% change in quantity demanded) = PED x (% change in price). Thus the percentage change in quantity demanded = -10 x -50%, = 500%. So there has been a 500% increase in quantity demanded from 10 units to 60 units following the price change. So at the new price of £1 and the new quantity demanded of 60 units, total revenue is now £1 x 60 = £60. This is greater than the original total revenue of £2 x 10 = £20, showing that a fall in the price of a good or service that has an elastic price elasticity of demand is likely to result in an increase in total revenue.

What is the distinction between movements along a supply curve and shifts of a supply curve?

In order to understand the distinction between movements along and shifts of a supply curve, it is first important to understand the concept of supply. Supply is defined as the ability and willingness of producers to provide a certain good or service at a given price within a certain period of time. According to the law of supply, there is a direct and positive relationship between the price of a good or service and the quantity supplied of this good or service. The main explanation for this is that firms are incentivised to produce more at higher prices as they are likely to make higher profits.

A movement along a supply curve is where a change in the price of a good or service results in a movement along the supply curve, likely resulting in a change in quantity supplied.

In the diagram above, an increase in price from P to P1 leads to a movement along the supply curve and an extension in quantity supplied from Q to Q1. 

In the diagram above, a decrease in price from P to P1 has resulted in a movement along the supply curve and a contraction of quantity supplied from Q to Q1.

A shift of the supply curve is where there is complete movement of the entire supply curve which occurs either outwards or inwards as a result of a change in one of or multiple conditions that influence supply.

The diagram above shows an outward shift of the supply curve, due to an increase in supply, from S to S1, for example, due to higher productivity of labour. As a result, at price P, the quantity supplied has increased and is now at Q1, rather than at Q.

The diagram above shows an inward shift of the supply curve, due to a fall in supply, from S to S1, for example, due to costs of production rising. At price P, the quantity supplied is now at Q1 which is less than it was before the inward shift of the supply curve at a quantity supplied of Q.

What are the factors that may cause a shift in the supply curve (conditions of supply)?

1. Levels of productivity. Higher levels of productivity result in a fall in the average cost for a firm, resulting in an outward shift of the supply curve. Falling productivity results in an inward shift of the supply curve.
2. Costs of production. An increase in the costs of production, for example, due to more expensive capital, will result in a rise in average costs, resulting in an inward shift of the supply curve. Falling costs of production will result in an outward shift of the supply curve.
3. Changes in technology. Improved technology may help to reduce average costs, resulting in an outward shift of the supply curve. If access to technology deteriorates, there is likely to be an inward shift of the supply curve.
4. Changes in climate. For some producers, the amount they can supply is heavily weather and climate-dependent. If weather conditions improve, this may increase the ability of a producer to supply a good or service at any given price, resulting in an outward shift of the supply curve. A deterioration in weather conditions for a producer may result in an inward shift of the supply curve.

What is meant by price elasticity of supply?

Price Elasticity of Supply (PES) is a measure of the responsiveness of quantity supplied of a good or service when there is a change in the price of the good or service.

What is the formula to calculate price elasticity of supply?

Price Elasticity of Supply (PES) = (% change in quantity supplied) / (% change in price).

How can numerical values of price elasticity of supply be interpreted (perfectly and relatively elastic, and perfectly and relatively inelastic?

Perfectly elastic price elasticity of supply (price elasticity of supply: ∞) occurs where a change in price results in an infinite change in quantity supplied.

Relatively elastic price elasticity of supply (price elasticity of supply: 1 < price elasticity of supply < ∞) occurs where a change in price results in a more than proportionate change in quantity supplied.

Perfectly inelastic price elasticity of supply (price elasticity of supply: 0) occurs where a change in price results in no change in quantity supplied.

Relatively inelastic price elasticity of supply (price elasticity of supply: 0 < price elasticity of supply < 1) occurs where a change in price results in a less than proportionate change in quantity supplied.

What are some factors that influence the price elasticity of supply?

1. How easy it is to store the final product. If the final product that a firm produces is easy to store, then a firm is likely to be able to be more responsive to changes in price, as they can store goods when there is little demand and save the goods for when the price rises, likely resulting in a more elastic price elasticity of supply. If it is hard to store the final product, then the elasticity of supply is likely to be more inelastic.
2. Length of the supply chain. A longer supply chain will likely result in a more inelastic price elasticity of supply as there are often delays in long supply chains, resulting in a fall in the responsiveness of the quantity supplied to a change in price. A shorter supply chain will likely result in a more elastic price elasticity of supply.
3. Level of technology. High levels of technology are likely to result in improvements in the efficiency of the production of goods and services, likely leading to the quantity supplied becoming more responsive to changes in price, resulting in a more elastic price elasticity of supply. Low levels of technology are likely to result in a more inelastic price elasticity of supply.
4. Weather. Poor weather conditions may result in the quantity supplied of some goods such as agricultural goods becoming less responsive to changes in price, resulting in a more inelastic price elasticity of supply. Good weather conditions are likely to result in a more elastic price elasticity of supply.
5. Spare capacity. If a firm is operating near full capacity, it is unlikely that the firm will be able to increase production levels any further in the short run to match an increase in price, resulting in a more inelastic price elasticity of supply. If a firm is not operating near full capacity, the price elasticity of supply is likely to be more elastic.

What is the distinction between the short run and long run in economics and what is its significance for elasticity of supply?

The short run in economics is where at least one of the factors of production used in producing goods and services is constant. As a result, the price elasticity of supply in the short run is likely to be more inelastic. An increase in price may mean that a firm would like to increase its level of production, but due to one factor of production being fixed in the short run, the firm is unable to increase its level of production significantly enough, resulting in the quantity supplied not being that responsive to a change in price.

The long run in economics is where all of the factors of production used in producing goods and services are variable. As a result, the price elasticity of supply in the long run is likely to be more elastic. This is because, as all factors of production are variable in the long run, a firm is likely to find it easier to increase its level of production in response to changes in price as none of the factors of production are fixed.

What is the equilibrium price and quantity and how are they determined?

The equilibrium price and quantity are the price and quantity of a good or service in a market found at the intersection of the supply and demand curve. The market is cleared at the equilibrium price, as there is no excess demand or supply.

In the above diagram, the equilibrium price is at price P, and the equilibrium quantity is at quantity Q, where the supply curve intersects the demand curve.

How can supply and demand diagrams be used to depict excess supply and excess demand?

In the above diagram, at price P1, there is excess supply. At price P1, the price is above the equilibrium price of P where the market would clear. The quantity supplied (Qs) is greater than the quantity demanded (Qd), resulting in excess supply between the quantity demanded (Qd) and the quantity supplied (Qs). 

In the above diagram, at price P1, there is excess demand. At price P1, the price is below the equilibrium price of P where the market would clear. The quantity demanded (Qd) is greater than the quantity supplied (Qs), resulting in excess demand between the quantity supplied (Qs) and the quantity demanded (Qd).

How do market forces operate to eliminate excess demand and excess supply?

Excess demand results in a shortage of a good or service. As a result of this shortage, there is pressure on prices to rise. This is because, consumers are competing with each other in an attempt to purchase this good or service, which results in a rise in the price of this good or service, which incentivises firms to produce more of this good or service, leading to an extension in quantity supplied. As a result of higher prices, some consumers may not be able to afford this good or service, resulting in a contraction in the quantity demanded. Eventually, the extension in quantity supplied and contraction in quantity demanded will help bring about the market equilibrium price and quantity.

Excess supply results in there being a surplus of a good or service. As a result of this surplus, prices are likely to fall. This is because, firms realise that their goods and services are not selling when there is excess supply, meaning they have to reduce their prices to sell more and clear their excess stock of goods and services, resulting in a contraction in the quantity supplied. As a result of these firms lowering their prices to sell more, there is likely to be an extension in quantity demanded due to the lower price. Eventually, the contraction in quantity supplied and extension in quantity demanded will help bring about the market equilibrium price and quantity.

How can supply and demand diagrams be used to show how shifts in demand and supply curves cause the equilibrium price and quantity to change in real-world situations?

To show how shifts of the demand and supply curve cause a change in the equilibrium price and quantity in real-world situations, it is important to show the effects of the shifts of the supply and demand curves more generally. 

As shown in the above diagram, a fall in demand is likely to result in an inward shift of the demand curve from D to D1, resulting in a fall in the equilibrium price from P to P1 and a fall in the equilibrium quantity from Q to Q1. A rise in demand is likely to result in an outward shift of the demand curve from D to D2, resulting in an increase in the equilibrium price from P to P2 and an increase in the equilibrium quantity from Q to Q2.

As shown in the above diagram, an increase in supply is likely to result in an outward shift of the supply curve from S to S2. The equilibrium price falls from P to P2 and the equilibrium quantity rises from Q to Q2. A fall in supply is likely to result in an inward shift of the supply curve from S to S1. This results in an increase in the equilibrium price from P to P1 and a fall in the equilibrium quantity from Q to Q1.

Real-world situations can be modelled using these demand and supply diagrams, which can help explain changes in the equilibrium price and quantity in these real-world situations. For example, a subsidy given to firms that construct houses is likely to lead to an outward shift of supply which is likely to lead to a fall in the equilibrium price of houses and an increase in the equilibrium quantity of houses (as previously explained and demonstrated in the above diagrams). Another example could be that coffee producers may see a rise in demand if the price of tea (a substitute good for coffee) rises. This leads to an outward shift of the demand curve for coffee producers, resulting in an increase in the equilibrium price of coffee and an increase in the equilibrium quantity of coffee (as previously explained and demonstrated in the above diagrams).

How is rationing a function of the price mechanism in allocating resources?

Rationing is a function of the price mechanism because when prices rise for a good or service, the good is rationed as only those who are able to pay for the more expensive good or service will be able to purchase it, rationing resources.

How are incentives a function of the price mechanism in allocating resources?

Firms are incentivised to adapt to market conditions, which affects where they allocate resources. When the price is falling due to falling consumer demand, firms aren't incentivised to produce as many goods and services as before as they are likely to make lower profits at a lower price. When the price rises due to an increase in consumer demand, producers are incentivised to produce more and match this demand as they are incentivised by higher profits as there is a higher price, allocating resources to where they are demanded.

How is signalling a function of the price mechanism in allocating resources?

Prices signal to producers where they should allocate their resources. A high price due to high consumer demand signals to producers that they should be producing more of this good or service as it is in demand, whereas a low price due to low consumer demand signals to producers that they should reduce the production of this good or service.

How can the price mechanism be applied to different markets, including local, national and global markets?

The price mechanism tries to allocate resources efficiently within markets.

A hypothetical example in a local market of the price mechanism could be a baker. A baker in a village may observe that consumers are purchasing more bread, reflecting an increase in demand. This signals to the baker that they should increase production to match the demand. The baker is also incentivised to produce more bread due to the possibility of higher profit as there is likely to be an increase in price following the increase in demand. An increase in price will also ration the amount of bread available as only the consumers who have the financial ability to do so will be able to purchase the bread at the higher price.

Within a national market, for example, the market for new cars in a certain country, the hypothetical release of new cars may increase the demand for new cars within a country. This signals to producers to produce more new cars as there is greater demand. This greater demand may lead to higher prices which incentivises the producers of these new cars to produce more as they are incentivised by higher profits. This increase in price is likely to ration the amount of new cars available as only those who are financially able will be able to purchase these new cars at the higher price.

Within a global market, for example, the market for coal, there may hypothetically be an increase in the demand for coal if there is economic growth in emerging markets and a reduction in supply due to the closure of coal mines, likely resulting in an increase in price. This increase in price acts as a signal to producers around the world that supply and demand conditions in the coal market are changing, with a higher price signalling to producers to produce more. A higher price is likely to incentivise coal producers to produce more as they are incentivised by higher profits at higher prices. Simultaneously, firms around the world are likely incentivised to reduce their consumption of coal due to the higher price. Higher-priced coal will also ration coal within the global market as only those who have the financial ability to purchase coal will be able to purchase it following the increase in the price of coal.

What is the distinction between consumer and producer surplus?

Consumer surplus is defined as the difference between the price that consumers are willing and able to purchase a good or service at and the price that consumers actually pay for the good or service. Producer surplus is the difference between the price producers receive for the sale of their good or service and the minimum price at which producers are willing and able to sell their good or service.

How can supply and demand diagrams illustrate consumer and producer surplus?

The diagram above shows the area of consumer surplus at the equilibrium price of P and the equilibrium quantity of Q. The area of consumer surplus is the triangle PAB. 

The diagram above shows the area of producer surplus at the equilibrium price of P and the equilibrium quantity of Q. The area of producer surplus is the triangle CPB.

How can changes in supply and demand affect consumer and producer surplus?

As shown in the above diagram, the original equilibrium is where supply (S) is equal to demand (D) at the equilibrium price of P and the equilibrium quantity of Q, with a consumer surplus of area PBY and a producer surplus of area EPY. Following an increase in demand leading to an outward shift of the demand curve from D to D2 resulting in an increase in the equilibrium price from P to P2 and an increase in the equilibrium quantity from Q to Q2, consumer surplus rises, with a new consumer surplus area of P2CZ, and producer surplus rises with a new producer surplus area of EP2Z. A fall in demand leading to an inward shift of the demand curve from D to D1 results in a fall in the equilibrium price from P to P1 and a fall in the equilibrium quantity from Q to Q1 with a fall in consumer surplus, with a new consumer surplus area of P1AX, and producer surplus falls with a new producer surplus area of EP1X.

As shown in the above diagram, the original equilibrium is where supply (S) equals demand (D) at the equilibrium price of P and the equilibrium quantity of Q, where there is a consumer surplus of area PEY and a producer surplus of area BPY. An increase in supply results in an outward shift of the supply curve from S to S2 with a fall in the equilibrium price from P to P2 and an increase in quantity from Q to Q2, with an increase in consumer surplus with a new consumer surplus area of P2EZ, and an increase in producer surplus with a new producer surplus area of AP2Z. A fall in supply results in an inward shift of the supply curve from S to S1 resulting in a rise in the equilibrium price from P to P1 and a fall in the equilibrium quantity from Q to Q1. This results in a fall in consumer surplus with a new consumer surplus area of P1EX and a fall in producer surplus with a new producer surplus area of CP1X.

How can supply and demand analysis and elasticity analysis be used to show the impact of indirect taxes on consumers, producers and government?

An indirect tax is a tax which is placed on goods and services. The imposition of an indirect tax is likely to result in a fall in supply and an inward shift of the supply curve. There are two types of indirect tax, a specific tax and an ad valorem tax. A specific tax levies a set amount of tax on each unit of a good or service. An ad valorem tax levies a certain percentage of tax on the value of a good or service.

The above diagram shows the likely effects of the imposition of a specific tax on a good or service. The imposition of a specific tax results in a vertical inward shift of the supply curve from S to S1, with the size of the specific tax being the difference between P1 and P0. Consumers are likely to have to pay higher prices for the good or service due to the price rise from P to P1 as a result of the inward shift of supply. Moreover, producers are likely to see higher costs and a fall in the quantity of the good or service that they sell, with a reduction in the quantity in the diagram above from Q to Q1, the government will also make tax revenue of area P0P1YZ.

The above diagram shows the effects of the imposition of an ad valorem tax on a good or service. An ad valorem tax results in a pivotal inward shift of the supply curve from S to S1. There is a pivot because at higher prices the amount of tax paid is greater than at lower prices. For example, if there was an ad valorem tax of 10%, 10% of £10 = £1 whereas 10% of £20 is £2. The amount of tax at each quantity is the distance between the two supply curves. As a result of the ad valorem tax in the diagram above, the price has risen from P to P1. This results in higher prices for consumers. Producers are also likely to incur higher costs of production and sell less, with quantity falling from Q to Q1. The government is likely to generate tax revenue of area P0P1YZ.

The size of some of these effects will be influenced by elasticities. For example, when demand is relatively price inelastic, there will likely be a fairly large increase in price with a less than proportionate fall in quantity, and when demand is relatively price elastic, there will likely be a relatively small increase in price with a more than proportionate fall in quantity. When demand is perfectly elastic, there will be no effect on price, with only quantity falling. When demand is perfectly inelastic, the quantity will not change but the price will rise. Elasticities may influence how much a government taxes a good or service.

How can supply and demand analysis and elasticity analysis be used to show the incidence of indirect taxes on consumers and producers?

The above diagram shows the imposition of a specific tax on a good or service. The incidence (burden) of the specific tax on the consumer is area PP1AB. The incidence (burden) of the specific tax on the producer is area P0PBC.

The above diagram shows the imposition of an ad valorem tax on a good or service. The incidence (burden) of the ad valorem tax on the consumer is area PP1AB, and the incidence (burden) of the ad valorem tax on the producer is area P0PBC.

Elasticities of demand and supply will impact the incidence of the indirect tax on the consumer and the producer. In general, when supply is relatively price inelastic or demand is relatively price elastic, there will be a greater incidence (burden) on the producer than the consumer. In general, when supply is relatively price elastic or demand is relatively price inelastic, there will be a greater incidence (burden) on the consumer than the producer.

How can supply and demand analysis and elasticity analysis be used to show the impact of subsidies on consumers, producers and government?

A subsidy is where the government will give an amount of money to firms in order to stimulate the production of certain goods and services. A subsidy will likely increase supply resulting in an outward shift of the supply curve.

As shown in the above diagram, a subsidy has resulted in an outward shift of the supply curve from S to S1. The size of the subsidy per unit is the difference between P0 and P1. The reduction in price from P to P1 is likely to benefit consumers. The increase in quantity from Q to Q1 results in producers selling more goods and services. The total area of government spending on the subsidy is area P1P0YZ.

Elasticities will change the size of some of these effects. When demand is relatively price elastic, there is likely to be a small fall in price and a more than proportionate increase in quantity. When demand is relatively inelastic, there is likely to be a large fall in price and a less than proportionate increase in quantity. When demand is perfectly elastic, there will be no change in price, but an increase in quantity. When demand is perfectly inelastic, there will likely be a fall in price but no change in quantity. Elasticities may influence how much a government spends on subsidies.

How can supply and demand analysis and elasticity analysis be used to show the area that represents the producer subsidy and consumer subsidy?

In the diagram above, the area of consumer subsidy is area P1PYZ and the area of producer subsidy is area PP0XY.

Elasticities will influence the area of consumer subsidy and the area of producer subsidy. When demand is relatively price elastic or supply is relatively price inelastic, the producer subsidy will be greater than the consumer subsidy. When demand is relatively price inelastic or supply is relatively price elastic, the consumer subsidy will be greater than the producer subsidy.

How is the influence of other people's behaviour a reason why consumers may not behave rationally?

Sometimes, a consumer may be influenced by the behaviour of others, meaning that the consumer does not act in a way to maximise their own utility. For example, a consumer may buy a trendy product that they may not actually gain that much utility from, but they may buy it solely in order to keep up with trends. Thus, the consumer may not behave rationally as a result of the influence of other people's behaviour.

How is the importance of habitual behaviour a reason why consumers may not behave rationally?

Some consumers may stick to familiar and habitual behaviours. This may result in a consumer not evaluating all the options they have available to them, for example, the consumer may not consider lower-priced alternatives to a good or service that they repeatedly purchase. As a result, the consumer may not act in a way that maximises their utility gained from goods and services, hence the consumer may not behave rationally as a result of habitual behaviour.

How is consumer weakness at computation a reason why consumers may not behave rationally?

Sometimes, a consumer may not know exactly how much of a good or service they require, either leading to the consumer buying too much or too little of a good or service, thus reducing the overall utility a consumer gains from these goods and services. Hence the consumer may not behave rationally as a result of consumer weakness at computation.