Section 1.3.1Unit 1: Markets in Action
Unit 1: Markets in Action
Introductory Concepts
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Demand is the quantity of a good consumers are willing and able to buy at each price — not just what they want, but what they can actually afford.
Demand refers to the quantity of a product that consumers are willing and able to purchase at a given price in a given time period. The key phrase is "willing and able" — you might want a Ferrari, but unless you have the income to buy one, you do not represent effective demand.
The law of demand states that, ceteris paribus (all other things being equal), as the price of a good rises, the quantity demanded falls, and vice versa. This inverse relationship exists because higher prices reduce consumers' purchasing power and because cheaper substitutes become relatively more attractive.
On a demand diagram, price is on the vertical axis and quantity on the horizontal axis. The demand curve slopes downward from left to right. A change in price causes a movement along the demand curve — not a shift.
Real Example: Sony cut the price of the PS5 in several markets to boost sales in 2024. As the price dropped, quantity demanded rose sharply — a textbook movement along the demand curve as gaming became affordable to a wider group of consumers.
Exam Matters: Examiners deduct marks if you say "demand shifts" when you mean a price-driven change. Use the term "quantity demanded" for movements along the curve and reserve "demand" for shifts of the whole curve caused by non-price factors.
When something other than price changes — income, tastes, substitutes, population — the entire demand curve moves left or right.
A shift in demand means the entire demand curve moves to a new position. At every possible price, consumers now want to buy more (rightward shift) or less (leftward shift) than before. Shifts are caused by changes in non-price factors, not by a change in the good's own price.
You must always identify the specific factor causing the shift and explain the direction. Saying "demand increased" without naming a non-price cause will cost you marks in an exam.
Real Example: Oatly experienced a massive rightward shift in demand for oat milk as consumer tastes moved toward plant-based diets in 2020-2023. This was not a price change — it was a shift driven by health awareness and environmental concerns, moving the whole demand curve to the right.
Exam Matters: In diagram questions, examiners want you to label two demand curves (D1 and D2), show the direction of the shift, and state the specific non-price factor causing it. A shift without an identified cause earns partial marks at best.
Supply is the quantity of a good that firms are willing and able to offer for sale at each price — higher prices incentivise greater production.
Supply refers to the quantity of a product that firms are willing and able to offer for sale at a given price in a given time period. Just as demand requires willingness and ability from consumers, supply requires that producers both want to sell and have the capacity to produce.
The law of supply states that, ceteris paribus, as the price of a good rises, the quantity supplied increases. This positive relationship exists because higher prices make production more profitable, encouraging existing firms to produce more and potentially attracting new firms into the market.
The supply curve slopes upward from left to right on a diagram. A change in the good's own price causes a movement along the supply curve. You should never describe a price change as "supply shifting" — that is a common error.
Real Example: UK strawberry farmers increase the quantity they supply during summer when retail prices are highest, and reduce output during off-peak months. The higher summer price makes extra labour and greenhouse costs worthwhile, showing the law of supply in action.
Exam Matters: Just as with demand, examiners distinguish sharply between movements along the supply curve (price changes) and shifts (non-price factors). Precise language is essential — always specify whether you mean quantity supplied or supply itself.
Changes in production costs, technology, taxes or the number of firms shift the whole supply curve — more supply means a rightward shift.
A shift in supply occurs when the entire supply curve moves to a new position. At every price level, firms are now willing to supply more (rightward shift) or less (leftward shift). These shifts are caused by changes in conditions of supply — factors other than the good's own price.
You must be precise about the direction of the shift and the cause. A rightward shift means more is supplied at every price; a leftward shift means less is supplied at every price.
Real Example: Tesla's Gigafactory investments in battery production technology dramatically reduced the per-unit cost of lithium-ion batteries. This technological advancement shifted the supply curve for electric vehicles to the right, enabling Tesla to produce more cars at every price point.
Exam Matters: When drawing supply shifts, always label S1 and S2 clearly, state the specific factor causing the shift, and explain why it affects the cost or willingness to produce. Vague answers such as "supply goes up" without a causal factor will not score well.
Equilibrium is the price where quantity demanded equals quantity supplied — there is no tendency for the market to change.
Market equilibrium occurs at the price where the quantity demanded by consumers exactly equals the quantity supplied by producers. At this point, there is no excess supply (surplus) and no excess demand (shortage), so there is no pressure for the price to change.
On a diagram, equilibrium is where the demand and supply curves intersect. The equilibrium price (Pe) is found on the vertical axis and the equilibrium quantity (Qe) on the horizontal axis. Any price above Pe creates a surplus — firms cannot sell all they produce, so they cut prices. Any price below Pe creates a shortage — consumers compete for limited stock, pushing prices up.
This self-correcting mechanism is called the price mechanism. Markets naturally move toward equilibrium because surpluses and shortages create incentives for buyers and sellers to adjust their behaviour.
Real Example: UK housing markets in areas like London show persistent excess demand because supply is constrained by planning regulations. When quantity demanded far exceeds quantity supplied at the current price, prices are pushed above the level most buyers can afford, demonstrating disequilibrium in action.
Exam Matters: Always label your equilibrium diagram with Pe and Qe at the intersection. Examiners expect you to explain what happens above and below equilibrium — describe both the surplus and shortage mechanisms to show you understand the full adjustment process.
When demand or supply shifts, the equilibrium price and quantity both change — you must trace the cause through to the new intersection.
When the demand curve or supply curve shifts, the market moves to a new equilibrium. You need to identify which curve has shifted, in which direction, and then read off the new equilibrium price and quantity from the diagram.
In more complex scenarios, both curves may shift simultaneously. When that happens, you can determine the effect on one variable but the effect on the other depends on the relative size of the shifts. You should state this uncertainty clearly in exam answers.
Real Example: Global oil prices spiked in 2022 after Russia's invasion of Ukraine reduced supply (leftward shift of supply). At the same time, post-pandemic recovery increased demand (rightward shift). Both shifts pushed the equilibrium price sharply upward, while the net effect on quantity depended on which shift was larger.
Exam Matters: Diagram questions often require you to show the old and new equilibrium clearly. Label the original curves D1/S1 and the new ones D2/S2, mark Pe1/Qe1 and Pe2/Qe2, and use arrows to show the direction of change. Half the marks come from the diagram itself.
PED measures how sensitive quantity demanded is to a price change — the bigger the number, the more consumers react to a price change.
Price elasticity of demand (PED) measures the responsiveness of the quantity demanded of a good to a change in its price. It is calculated using the formula: PED = % change in quantity demanded / % change in price. The result is always negative (because of the inverse relationship between price and demand), but we often refer to the absolute value.
If PED is greater than 1 (in absolute terms), demand is price elastic — a small price change causes a proportionally larger change in quantity demanded. If PED is less than 1, demand is price inelastic — quantity demanded is relatively unresponsive to price changes. If PED equals exactly 1, demand is unit elastic.
You should always show your working clearly in exam calculations. State the formula, substitute the figures, and interpret the result by saying whether demand is elastic or inelastic and what this means for the business.
Real Example: Ryanair knows that leisure travellers have highly elastic demand — a 10% fare increase could cut bookings by more than 10%. This is why Ryanair keeps base fares extremely low and earns revenue from inelastic add-ons like seat selection and baggage, where customers are less sensitive to price.
Exam Matters: Calculation questions award marks for the formula, correct substitution, the final answer, and your interpretation. Even if the arithmetic is wrong, you can still pick up method marks — so always show every step of your working.
The more substitutes a product has, the less essential it is, and the longer consumers have to adjust, the more elastic its demand will be.
Several factors determine whether demand for a particular good is elastic or inelastic. The most important factor is the availability of substitutes — if there are many close alternatives, consumers can easily switch when the price rises, making demand elastic.
You should be able to apply these factors to any product in a case study. Identify which factors apply, explain how they affect PED, and use this to advise the business on its pricing strategy.
Real Example: UK energy suppliers face inelastic demand because electricity and gas are necessities with few practical substitutes in the short run. Even when British Gas raised prices by 54% in April 2022, most households had little choice but to continue buying energy, demonstrating classic inelastic demand.
Exam Matters: Higher-mark questions ask you to evaluate whether a product has elastic or inelastic demand. Structure your answer by considering multiple factors, reaching a judgement, and supporting it with data or context from the question. One-factor answers rarely score full marks.
If demand is elastic, lowering prices raises total revenue; if demand is inelastic, raising prices raises total revenue — this is the key pricing insight.
The link between PED and total revenue is one of the most important concepts in business. Total revenue equals price multiplied by quantity sold (TR = P x Q). The impact of a price change on total revenue depends entirely on whether demand is elastic or inelastic.
If demand is price elastic (PED > 1), a price cut increases total revenue because the percentage rise in quantity demanded is greater than the percentage fall in price. Conversely, a price rise reduces total revenue because customers desert you in large numbers.
This insight is crucial for pricing strategy. You should recommend price rises for inelastic products and price cuts for elastic products when the goal is to maximise revenue.
Real Example: UK government tobacco taxation consistently raises cigarette prices, yet tax revenue keeps rising. Because nicotine is addictive and demand is highly inelastic, the percentage fall in quantity demanded is far smaller than the percentage increase in price, so total tax revenue increases each year.
Exam Matters: This is a favourite exam topic. When advising on pricing, always state the PED value or whether demand is elastic/inelastic, then explain the revenue effect using the formula TR = P x Q. Show numerically or logically why revenue rises or falls.
YED measures how quantity demanded responds to income changes — its sign tells you whether the good is normal (positive) or inferior (negative).
Income elasticity of demand (YED) measures the responsiveness of demand to a change in consumer income. The formula is: YED = % change in quantity demanded / % change in income. Unlike PED, the sign of YED is meaningful — it tells you the type of good.
If YED is positive, the good is a normal good — demand rises as income rises. Most goods fall into this category. If YED is negative, the good is an inferior good — demand falls as income rises because consumers trade up to better alternatives.
Normal goods with YED greater than 1 are called luxury goods or income-elastic goods — demand grows faster than income. Normal goods with YED between 0 and 1 are necessities or income-inelastic goods — demand grows but more slowly than income.
Real Example: Aldi and Lidl saw sales surge during the 2022-2023 cost-of-living crisis in the UK as real incomes fell. Their budget products have negative YED — when incomes fall, demand for cheaper alternatives rises, making discount supermarkets the winners during economic downturns.
Exam Matters: YED calculation questions require you to show the formula, substitute correctly, state the sign, and interpret it. The most common error is giving the right number but failing to explain what it means — always classify the good as normal/inferior and luxury/necessity.
YED helps businesses predict how economic booms and recessions will affect their sales, allowing them to plan product portfolios accordingly.
Understanding YED is vital for strategic planning. During an economic boom, incomes rise and demand for luxury goods (high positive YED) increases rapidly — businesses selling these goods can expect strong growth. However, demand for inferior goods (negative YED) will fall during booms as consumers trade up.
During a recession, the opposite happens. Demand for luxury goods drops sharply while demand for inferior goods rises. Businesses that sell only income-elastic products are vulnerable in downturns, which is why diversification across product types with different YED values can stabilise revenue.
Businesses also use YED to decide which markets to enter. If you expect long-term income growth in a developing economy, targeting luxury goods makes sense because demand will grow faster than income. In stagnant economies, necessities and inferior goods may be safer bets.
Real Example: LVMH (owner of Louis Vuitton) reported record revenues of over EUR 86 billion in 2023, driven by rising incomes among wealthy consumers globally. Their luxury portfolio has a high positive YED, meaning profits soar during economic growth but could fall sharply in a global recession.
Exam Matters: Extended-answer questions often ask you to evaluate how economic changes affect a specific business. Use YED to structure your argument — classify the firm's products, predict the demand impact, and evaluate whether the business is well-positioned to cope with the change.
Demand is the quantity of a good consumers are willing and able to buy at each price — not just what they want, but what they can actually afford.
When something other than price changes — income, tastes, substitutes, population — the entire demand curve moves left or right.