Price Determination
Price Determination
FREE RESOURCES
EXAM RESOURCES
PREMIUM
At the equilibrium price, the quantity buyers want to buy equals the quantity sellers want to sell.
Think about a fish market on a Saturday morning. Buyers have decided how many kilos they want to buy at each price, and sellers have decided how many they want to sell. At a low price, buyers want a lot but sellers offer little. At a high price, buyers want little but sellers offer a lot. So at most prices, the quantity buyers want to buy is different from the quantity sellers want to sell.
At one price, the quantity buyers want to buy (the quantity demanded) exactly matches the quantity sellers want to sell (the quantity supplied).
Equilibrium price: the price at which the quantity demanded equals the quantity supplied, so there is no tendency for the price to change.
Equilibrium quantity: the quantity bought and sold at the equilibrium price, where the quantity demanded equals the quantity supplied.
Put simply, at the equilibrium price nothing pushes the price up or down. At this price the quantity supplied is just enough to meet the quantity demanded, so buyers have no reason to offer a higher price. The quantity demanded is just enough to buy the whole quantity supplied, so sellers have no reason to cut the price.
The schedule shows the daily market for cooking-gas cylinders in the town of Sabaya. Read along each row and compare the quantity demanded with the quantity supplied. Only one row matches: at $10, both are 600 cylinders a day. So the equilibrium price is $10, and the equilibrium quantity is 600 cylinders a day.
At every other price, the two quantities are different. At $16, for example, the quantity supplied is 1,200 cylinders a day, but the quantity demanded is only 300. At these prices, the market is in disequilibrium.
Disequilibrium: a situation in which the quantity demanded does not equal the quantity supplied at the current price, so the price has a tendency to change.
Put simply, in disequilibrium some buyers cannot buy the quantity they want at the current price, or some sellers cannot sell the quantity they want. So someone has a reason to change the price.
Equilibrium tells you only one thing: the quantity demanded equals the quantity supplied. It does not mean that a large quantity is traded. It does not mean that sellers make a profit either, because profit also depends on their costs.
Real Example: The Indian Energy Exchange runs a day-ahead market for electricity. Buyers and sellers say how much they would buy or sell at each price. For each quarter-hour of the next day, the exchange combines the buyers' bids into a demand schedule and the sellers' offers into a supply schedule. Trades take place at the price where the quantity demanded equals the quantity supplied. A real market finds its equilibrium price just as you read Sabaya's.
On a diagram, the equilibrium is where the demand and supply curves cross, giving both a price and a quantity.
A diagram shows the same information as a schedule, drawn as two curves. Price goes on the vertical axis and quantity on the horizontal axis. A point on the demand curve tells you the quantity demanded at one price. A point on the supply curve tells you the quantity supplied at one price.
The demand curve slopes down, because at a lower price more people are willing and able to buy, so the quantity demanded rises. The supply curve slopes up, because at a higher price each unit earns sellers more, so the quantity supplied rises. So the two curves can cross at only one point. The crossing is the only point that lies on both curves. So at that price, both curves show the same quantity: quantity demanded equals quantity supplied. That is why the crossing shows the equilibrium.
Read the crossing off both axes. A dashed line from the crossing across to the vertical axis gives the equilibrium price. Another dashed line from the crossing down to the horizontal axis gives the equilibrium quantity. In the Sabaya market for cooking-gas cylinders, they are $10 and 600 cylinders a day. An equilibrium is always this pair: a price on its own is only half the answer.
You can read any other price in the same way. Draw a horizontal line across from that price. Where it meets the demand curve, read down to find the quantity demanded. Where it meets the supply curve, read down to find the quantity supplied.
Exam Matters: Label both axes with units, and label each curve. Then draw dashed lines from the crossing to both axes, and label the equilibrium price and the equilibrium quantity.
Away from the equilibrium price, quantity demanded and quantity supplied differ, and the gap puts pressure on the price.
In Sabaya, the equilibrium price of a cooking-gas cylinder is $10. Suppose the price is only $7. At this lower price, the quantity demanded is greater than at $10, but each cylinder earns sellers less, so the quantity supplied is smaller than at $10. On the diagram, the line at $7 meets the supply curve at 300 cylinders a day and the demand curve at 750. So some buyers who will pay that price cannot get a cylinder.
Excess demand: the amount by which quantity demanded exceeds quantity supplied at a price below the equilibrium price.
Put simply, excess demand is a shortage at that price. It is a number of cylinders, not a price: here, the 450 cylinders a day that buyers would buy at $7 but cannot get.
Now suppose the price is $13, above the equilibrium. At this higher price, each cylinder earns sellers more, so the quantity supplied is greater than at $10, but the quantity demanded is smaller: 900 supplied, against only 450 demanded. So some sellers cannot sell the whole quantity supplied: some cylinders stay unsold.
Excess supply: the amount by which quantity supplied exceeds quantity demanded at a price above the equilibrium price.
Put simply, excess supply is a surplus at that price: cylinders that sellers want to sell but cannot.
On the diagram, each gap runs along the price line, from one curve across to the other. So you measure it horizontally, and read its size off the quantity axis.
Excess demand, found only below the equilibrium price, puts upward pressure on the price. Excess supply, found only above it, puts downward pressure on the price.
Real Example: In 2024 about 13 million fans tried to buy tickets for two Coldplay concerts in Mumbai, at a stadium holding roughly 42,000 a night. The tickets were all sold almost at once, and so were those for a third night. Resale sites listed tickets far above their original price. This shows excess demand: the ticket price was set far below the equilibrium, where the quantity of tickets demanded would equal the number of seats.
When quantity demanded and quantity supplied are not equal, the price moves until they are.
In Sabaya, the equilibrium price of a cooking-gas cylinder is $10. Suppose the price is $7 instead. At $7, the quantity demanded is 750 cylinders a day, but the quantity supplied is only 300.
Above the equilibrium price, the same forces reverse each step. At $13, there is a surplus (excess supply) of 450: the quantity supplied is 900 but the quantity demanded is only 450. Sellers cut the price to sell their unsold cylinders. As the price falls, buyers buy more, so the quantity demanded extends, and each cylinder earns sellers less, so the quantity supplied contracts, until both are 600 at $10.
Market forces: the forces of demand and supply which, through the actions of buyers and sellers, push the price towards the equilibrium.
Put simply, market forces are what buyers and sellers do when they cannot buy or sell the quantity they want at the current price. Neither curve moves. Only the price changes, and the change in price moves both quantities along their curves.
At $10, the quantity supplied equals the quantity demanded, so there is no shortage and no surplus: the market clears. This is why the equilibrium price is also called the market-clearing price.
How quickly market forces close a gap depends on how quickly the price can change. A fish price can change within hours. A price that is fixed for a year, such as a rent in a one-year contract, cannot change until the contract ends, so a shortage or a surplus can last until then.
Real Example: Lasalgaon, in India, is Asia's largest wholesale onion market. Farmers bring onions by truck, and traders bid for each load. On one Monday in October 2025, 6,464 quintals arrived (a quintal is 100 kg), and the price rose to ₹1,325 a quintal. No farmer or trader set that price. It came from the bidding, as traders competed for the onions that had arrived. This is market forces at work, not one seller's decision.
When only demand shifts, the equilibrium price and quantity change in the same direction.
Incomes in Sabaya rise, so families can afford more cooking gas. Demand for cylinders increases: at every price, the quantity demanded is 300 cylinders a day higher. The demand curve shifts right, from D₁ to D₂. The supply curve stays where it is. Nothing that affects sellers, such as the cost of filling a cylinder, has changed.
Why did the quantity supplied rise if the supply curve did not move? The supply curve already shows the quantity supplied at every price. When the price rose to $12, sellers moved up along it. Only a change in something other than the price, such as their costs, would shift it.
So one change has two kinds of effect. The demand curve shifts, which changes the price. The change in price then causes movements along the curves: an extension of supply along S and a contraction of demand along D₂.
A decrease in demand reverses each step. If demand decreases by 300 cylinders a day at every price, the quantity demanded at $10 is only 300 but the quantity supplied is still 600, so there is a surplus (excess supply) of 300 and the price falls. As it falls, the quantity supplied contracts along S and the quantity demanded extends along the new demand curve. The new equilibrium is $8 and 400 cylinders a day: a lower price and a smaller quantity.
Real Example: In 2024 Japan had a record 36.9 million foreign visitors, so demand for hotel rooms increased. In May that year, the average Tokyo hotel room cost 44% more than a year earlier. A city cannot build new hotels quickly, so in the short run supply is price inelastic: the quantity supplied changes little when the price changes. So most of the change was probably in the price, not in the quantity of rooms supplied.
Exam Matters: Draw D₂ to the right of D₁ and leave S where it is. Label both equilibria, and read each one off to the axes with dashed lines.
When only supply shifts, the equilibrium price and quantity change in opposite directions.
Sabaya's market for cooking-gas cylinders starts in equilibrium at $10 and 600 cylinders a day. Now suppose sellers find a cheaper way of filling the cylinders, and nothing changes for buyers.
A supply curve can also be read the other way: each point shows the price sellers need to receive to supply that quantity. With cheaper filling, sellers need $3 less for every quantity. So the supply curve shifts down and to the right, from S₁ to S₂. This is an increase in supply.
Before the shift, sellers needed $13 to supply 900 cylinders a day. Now they need only $10. So at the old price, $10, the quantity supplied is 900, but the quantity demanded is still 600: a surplus (excess supply) of 300, and the price falls.
As the price falls, the quantity demanded extends along D, and the quantity supplied contracts along S₂. They meet at $8, where both are 700 cylinders a day: a lower price and a larger quantity than before.
A decrease in supply reverses each step. If filling costs rise, so that sellers need $3 more for every quantity, the supply curve shifts up and to the left. At $10 the quantity supplied is then only 300 but the quantity demanded is still 600, so there is a shortage (excess demand) of 300 and the price rises. As it rises, the quantity supplied extends along the new supply curve and the quantity demanded contracts along D. The new equilibrium is $12 and 500 cylinders a day: a higher price and a smaller quantity.
When you know that only one curve has moved, the table shows you which one. If price and quantity moved in the same direction, demand shifted. If they moved in opposite directions, supply shifted.
Real Example: Drought halved Spain's olive oil harvest in 2022/23. Sales in Spain fell by a quarter early in the season. The 2023/24 harvest was halved too, and by January 2024 the price paid to producers for extra virgin olive oil had reached a record: almost €9 a kilo. This is how a decrease in supply works: the quantity sold falls and the price rises. When the harvest recovered, supply increased and the price fell below €4.
When both curves shift, one of price and quantity changes in a known direction, and the larger shift decides the other.
Demand and supply often change at the same time. Suppose incomes in Sabaya rise, so demand for cylinders increases by 300 cylinders a day at every price. In the same month a new filling plant opens, so supply increases by 150 cylinders a day at every price. The market starts at its equilibrium of $10 and 600 cylinders a day.
Take each shift on its own first. The increase in demand pushes the price up and the quantity up. The increase in supply pushes the price down and the quantity up.
Both shifts push the quantity up, so the quantity certainly rises. But the two shifts push the price in opposite directions, so the price moves the way the larger shift pushes it. Here demand's shift was the larger, so the price rose. Now reverse the sizes, so that demand increases by 150 and supply by 300. At $10 the quantity supplied is 900 and the quantity demanded is 750, so there is excess supply of 150. The price falls to $9, because supply's shift is the larger. The quantity rises to 800, because both shifts push the quantity up.
The same rule works for any pair of shifts. When both shifts push the price the same way, the direction of the price is certain, and the same is true for the quantity. When they push it in opposite directions, the larger shift decides:
The last two rows reverse the first two, because reversing both shifts reverses every push.
Real Example: In 2023 the world added far more renewable power than the year before, and three-quarters of it was solar. Factories could now make three times as many panels as in 2021, so supply increased sharply. The price of panels fell by almost half and the quantity sold rose. A lower price with a larger quantity is what an increase in supply gives, so any increase in demand was the smaller shift.
Exam Matters: When you draw both shifts on one diagram, move the curve with the larger shift further. Then the new price on your diagram matches what you write.
Consumer surplus is the extra value buyers get when they would have paid more than the price they actually pay.
In Sabaya, cooking-gas cylinders sell at the equilibrium price of $10, and 600 are bought a day. One household cooks every meal with gas and would pay up to $20 for a cylinder. Another would pay at most $11.
Willingness to pay: the highest price a consumer would pay for a unit of a good rather than go without it.
Put simply, it is the most a buyer would pay, and it is different for each buyer.
Consumer surplus: the difference between the price consumers are willing to pay for a good and the price they actually pay, summed over all units bought.
Put simply, it is the gap between what buyers would pay and what they do pay. Both households pay $10, so the first gains $10 of value and the second gains $1. Consumer surplus adds up these gains on every cylinder bought.
On the diagram, the demand curve shows each buyer's willingness to pay, from the highest on the left to the lowest on the right. For each buyer, the gap between the demand curve and the price line is that buyer's gain. The gap gets smaller from left to right. It is zero at the last cylinder bought, because that buyer would pay only the price. So the gains fill the triangle below the demand curve and above the price line.
Economists name an area by the letters at its corners. On the diagram, A is where the demand curve meets the price axis, at $22. B is the point on the price axis at $10, and E is the equilibrium, where the price line meets the demand curve. So consumer surplus is the triangle ABE.
So each day, Sabaya's buyers get $3,600 more value from their cylinders than they pay for them.
In 'consumer surplus', the word 'surplus' means a gain. It is different from a surplus (excess supply), where the quantity supplied is greater than the quantity demanded.
If the price rises and the demand curve does not move, buyers pay more for each cylinder and the quantity demanded contracts. The triangle is shorter and narrower than it was at the lower price, so consumer surplus falls.
Producer surplus is the extra that sellers gain when the price is higher than the least they would accept.
Supplying each cylinder has a cost, such as the gas to fill it. A seller will not accept a price below that cost, because the sale would lose money. Costs differ from seller to seller.
On the diagram, the supply curve shows the least each seller would accept. It rises from $4 for the seller with the lowest cost to $10 for the seller of the last cylinder sold. Every cylinder sells at $10, so on each cylinder, the seller gains the gap between the price and the least they would accept.
Producer surplus: the difference between the price producers actually receive and the lowest price they are willing to accept, summed over all units sold.
Put simply, it is the sellers' gain, as consumer surplus is the buyers' gain. On the diagram, C is where the supply curve meets the price axis, at $4. B is the point on the price axis at $10 and E is the equilibrium, so producer surplus is the triangle BCE: above the supply curve and below the price line.
So each day, Sabaya's sellers receive $1,800 more for their cylinders than the least they would accept.
Producer surplus is not profit. It is the money sellers receive minus only their variable costs. Variable costs change with output, such as the gas to fill each cylinder. Profit is the money received minus all costs, so profit also subtracts fixed costs, which do not change with output, such as the rent on a depot. So a firm whose fixed costs are larger than its producer surplus makes a loss.
Price × quantity is not producer surplus either. It is total revenue, the whole amount sellers receive: in Sabaya, 600 cylinders at $10 each, or $6,000 a day. It is not a gain for either side, because buyers pay it and sellers pay their costs from it.
Both triangles end at the quantity traded, 600 cylinders. Beyond it, buyers would pay less than sellers would accept, so no cylinders are traded and nobody gains from them.
Whether a gain is consumer or producer surplus depends on whether someone is buying or selling in that market. A restaurant that buys cylinders is a buyer in this market, so its gain is consumer surplus.
Which triangle is bigger depends on the slopes. Both triangles have the same base, so the taller one is bigger. Demand in Sabaya is steeper than supply. Over the same 600 cylinders, the demand curve reaches the price axis at A, $12 above the price, but the supply curve reaches it at C, only $6 below the price. So the consumer surplus triangle is twice as tall, and consumer surplus is twice producer surplus. With flat demand and steep supply, producer surplus would be bigger.
Real Example: Economists Chiara Farronato and Andrey Fradkin studied Airbnb in major US cities in 2014. They estimated that travellers gained about $305 million of consumer surplus, while hosts gained about $112 million of producer surplus. In these estimates, the same bookings created a gain on both sides of the market, and the buyers' gain was the larger.
When demand increases, producer surplus rises, and consumer surplus can rise too, because buyers' willingness to pay is higher.
Demand for cylinders in Sabaya increases by 300 cylinders a day at every price, so the demand curve shifts from D₁ to D₂. At $10, the quantity demanded is now 900 cylinders but the quantity supplied is still 600, so there is excess demand and the price rises to a new equilibrium at H: $12 and 800 cylinders a day.
Sellers clearly gain. They receive $2 more for each cylinder and sell 200 more, an extension of supply along S. The supply curve itself has not moved, so producer surplus is still measured from S.
Buyers seem to lose, because they pay $2 more. But consumer surplus is willingness to pay minus the price, and the demand curve shows willingness to pay. That curve has moved: D₂ shows buyers' new, higher willingness to pay. So consumer surplus is now measured from D₂.
Parallel shift: a shift in which the whole curve moves by the same amount at every price, so its slope does not change.
Put simply, every point on the curve moves the same distance. Before the shift, 900 cylinders were demanded only at $4. Now 900 are demanded at $10, so willingness to pay for that quantity has risen by $6. Because Sabaya's shift is parallel, it has risen by $6 at every quantity, so D₂ meets the price axis at F, $28, instead of $22.
Consumer surplus rises by $2,800, even though the price is higher. Two things explain it: willingness to pay rose by $6, which is more than the $2 rise in the price, and buyers also buy more cylinders.
This gives a rule you can use in an exam. When sloping straight-line curves shift in parallel, both surpluses move in the same direction as the quantity traded. A parallel shift keeps each curve's slope, and on a straight line the height of each triangle is the slope times its base. So the height stays in the same proportion to the base. In Sabaya, consumer surplus has a height of $12 on a base of 600 and $16 on a base of 800: both rise by a third. Producer surplus follows the same pattern. So each area grows or shrinks with the quantity traded.
A parallel decrease in demand reverses each change. Suppose demand decreases by 300 cylinders a day at every price. At $10, the quantity demanded is 300 and the quantity supplied is 600, so there is excess supply of 300, and the price falls to a new equilibrium at $8, where 400 cylinders are traded. Less is traded, so both surpluses fall, even though buyers pay less.
Be careful with one group. Suppose the extra demand comes from new buyers. The households that already bought cylinders are willing to pay no more than before, but they now pay $2 more, so their consumer surplus falls. In an exam, say which buyers you mean, because the rule describes buyers as a whole.
Real Example: In 2024 central banks bought more than 1,000 tonnes of gold, and the average gold price rose 23%. Jewellery buyers were not the source of the increase in demand, and at the higher price they bought 11% less gold. They are an example of buyers whose demand has not increased: they pay the higher price, so in the model they lose consumer surplus.
When supply increases, consumer surplus rises, and producer surplus can rise too, because the least sellers would accept falls.
Suppose every seller in Sabaya finds a cheaper way to fill cylinders and needs $3 less for every quantity. Supply increases: the supply curve makes a parallel shift down, from S₁ to S₂. At $10, the quantity supplied is now 900 cylinders but the quantity demanded is still 600, so there is excess supply and the price falls to a new equilibrium at K: $8 and 700 cylinders a day.
Buyers clearly gain. They pay $2 less for each cylinder and buy 100 more, an extension of demand along D. The demand curve itself has not moved, so consumer surplus is still measured from D.
Sellers seem to lose, because they receive $2 less. But producer surplus is the price minus the least sellers would accept, and the supply curve shows the least they would accept. That curve has moved: on S₂, the least sellers would accept is $3 lower at every quantity. So producer surplus is now measured from S₂, which meets the price axis at L, $1.
Producer surplus rises, although the price is lower. The least sellers would accept fell by $3, more than the $2 fall in the price, and sellers also sell more cylinders. So the $3 saving on each cylinder is shared: buyers get $2 of it through the lower price, and sellers keep $1.
The same rule holds here: with sloping straight-line curves and a parallel shift, each surplus grows or shrinks with the quantity traded. The quantity traded rose from 600 to 700, so both surpluses rose. The rule also works in reverse. Suppose every seller's costs rise by $3 at every quantity, so supply decreases. At $10, the quantity supplied is 300 and the quantity demanded is 600, so there is excess demand, and the price rises to a new equilibrium at $12, where 500 cylinders are traded. Less is traded, so both surpluses fall, even though sellers receive more.
A failed harvest also decreases supply, but it raises nobody's costs: it destroys part of the crop. The first kilos still cost the same to grow, so the supply curve still meets the price axis at the same price. Only the quantity supplied at each price falls, so the curve swings in instead of moving in parallel, and the rule does not apply. Buyers lose consumer surplus, because they now pay more and buy less. Growers whose crop survived gain, because they sell the same amount at a higher price. Whether growers as a whole gain depends on the price elasticity of demand: how much the quantity demanded responds to a change in price. If demand is price inelastic, the price rises by a larger percentage than the quantity falls. Growers' total revenue then rises while they supply fewer kilos, so their producer surplus is likely to rise too. If demand is price elastic, their total revenue falls. Whether their producer surplus falls too depends on how much they save in costs on the kilos they no longer supply.
When a good is scarce, a price that is free to move decides who gets it.
When there is not enough of a good for everyone who wants it, something has to decide who gets it. It could be a queue, a lottery or an official list. In a market, the price decides.
Price mechanism: the system in which prices, set by the interaction of demand and supply, decide how scarce resources are allocated between competing uses.
Put simply, nobody is in charge of who gets what. Demand and supply set the price, and then the price decides who gets each cylinder. The price mechanism does three jobs, called its functions. The first is rationing: sharing out a scarce good.
In Sabaya, a town where families cook with gas from cylinders, the market normally settles at $10 a cylinder, with 600 sold a day. Then very cold weather arrives, and families want more gas to heat their homes. Demand increases from D₁ to D₂: at every price, the quantity demanded is 300 cylinders a day higher, so at $10 it is now 900.
But no more cylinders can arrive today, so the quantity supplied is fixed at 600, whatever the price. On the diagram, today's supply is therefore a vertical line at 600: the same quantity at every price. At $10 the quantity demanded (900) is greater than the quantity supplied (600). This is a shortage (excess demand) of 300 cylinders.
The shortage pushes the price up, because buyers who cannot get a cylinder offer a higher price. As the price rises, the quantity demanded contracts along D₂: some buyers decide a cylinder is not worth that much to them, and others cannot afford it. Demand itself does not fall: D₂ stays where it is, and the higher price moves buyers up along it. At $16 the quantity demanded has fallen to 600, the same as the quantity supplied. The shortage is gone, so $16 is today's equilibrium price.
Rationing function: the role of price in sharing out a scarce good: as the price rises, only buyers who are willing and able to pay it obtain the good.
Put simply, the 600 cylinders go to the buyers who are willing and able to pay $16. They do not necessarily go to the buyers who need them most. A family that cooks every meal with gas, but cannot afford $16, does not get one. A household that wants a spare cylinder, and can afford one, gets it.
Rationing by price only works when the price can move. If the price were held at $10, the shortage would remain, and something else would decide who gets a cylinder, such as a queue.
Real Example: After seven years of drought, North Africa had fewer sheep for the Eid al-Adha festival in June 2025, and prices rose. In Algeria a sheep could sell for more than $1,200. Average incomes there were below $270 a month, so such a sheep cost more than four months of income. This is the rationing function at work: families who could not pay did not get a sheep, however much the festival mattered to them.
The same price rise gives sellers a reason to supply more and tells them that the good is scarce.
In Sabaya, very cold weather has increased demand for gas cylinders. Only 600 are in the town today, so the price has risen from $10 to $16 to ration them. The same price rise does two more jobs.
Why does a higher price bring more cylinders to Sabaya in the days that follow? Some cylinders cost more to bring to Sabaya than others, for example those from a filling plant further away. At $10, a cylinder that costs a seller $11 to bring would lose money. At $16, the same cylinder makes a profit.
Incentive function: the role of price in giving producers a reason to change their output: a higher price makes it profitable to increase the quantity supplied, and a lower price to reduce it.
Put simply, a higher price makes it worth supplying units that cost more to produce, so nobody has to order sellers to bring more.
But how do sellers elsewhere know that Sabaya has a shortage? Most of them never meet Sabaya's families or hear about the cold weather. They only see the price rise from $10 to $16, and that tells them there is a shortage.
Signalling function: the role of price changes in passing information to buyers and sellers about changes in the conditions of a market, such as a shortage or a surplus.
Put simply, a change in price is news about a market: a rising price signals a shortage, and a falling price signals a surplus. Sellers can act on that news without knowing its cause.
The signal and the incentive are two different things. The signal is the information that there is a shortage. The incentive is the reason to act on that information: an extra cylinder now earns more than it costs. Rationing is different again. It shares out the cylinders that exist today, while the incentive changes the quantity supplied in the days that follow.
Over the next days more cylinders can arrive, so today's vertical line no longer applies. The normal supply curve, S, shows the quantity sellers supply at each price once they have time to bring more. Sellers now respond to the price along S. At $16 the quantity supplied along S would be 1,200 cylinders, but the quantity demanded is only 600. This is a surplus (excess supply), so the price falls. It settles at $12, where the quantity demanded and the quantity supplied are both 800 a day. The quantity supplied is 800 instead of 600 because the price is higher than at the start. This is an extension of supply: a movement along S, not a shift of it.
The incentive works in reverse too. When the cold weather ends, demand decreases to its old level, and the price falls from $12 to $10. A cylinder that costs $11 to bring no longer earns more than it costs, so the quantity supplied falls from 800 to 600 along S. This is a contraction of supply.
A price signal can also mislead. The price rises in the same way whether the cold weather lasts a week or the whole winter. So the price cannot show how long the shortage will last. Sellers who bring extra cylinders for a shortage that ends soon may find that the price has already fallen again.
Real Example: Madagascar grows most of the world's vanilla. After a cyclone hit its crop in 2017, the price reached about $600 a kilo in 2018. In Uganda, one farmer started growing vanilla when buyers were paying 300,000 shillings a kilo. By 2023 he was selling a kilo for 30,000, a tenth as much. The high price signalled a shortage and made growing vanilla look profitable, but it could not show how long the shortage would last.
Exam Matters: When you show the incentive function on a diagram, leave the supply curve where it is. Draw an arrow along it from the old equilibrium to the new one, and label it extension of supply or contraction of supply.
One price change performs all three functions, and together they decide how scarce resources are used.
The three functions of price are rationing, signalling and incentive. They are not three separate mechanisms: one price change does all three jobs. The incentive takes longest, because sellers need time to respond.
Take the world market for liquefied natural gas (LNG), which is gas shipped by tanker, in 2022. That year, Europe needed more LNG to replace the gas that Russia had sent by pipeline. Demand for LNG in Europe increased sharply, and the shortage at the old price pushed the price up. That one price rise performed all three functions:
As a result, gas that would have gone to other buyers, such as those in South Asia, went to Europe instead. This is how the price mechanism allocates scarce resources.
Allocation of resources: the way an economy's scarce resources are divided between the production of different goods and services.
Put simply, allocation is how an economy decides what to make with its scarce resources. The same gas could make electricity in Dhaka or heat homes in Germany. In a market, prices decide how resources are used.
A falling price reverses each of these changes:
These three functions also have limits. The mechanism rations by ability to pay, so a poorer country or household may not get something it needs. Bangladesh bought part of its LNG under long-term contracts (agreements to buy gas for many years) and the rest at the market price. By mid-2022 the market price was far above the contract price: the last cargo Bangladesh bought at the market price cost $24.75 for each unit of gas, against about $14 under its long-term contracts. It bought no LNG at the market price for July or August. The prime minister said power cuts would be scheduled.
Sellers can also be slow to respond. When new supply takes years to arrive, as with a new mine, the quantity supplied cannot rise at once. The price stays high until the quantity supplied rises.
Real Example: The world price of coffee fell from about $2.80 a pound in 2011 to about $1.12 in 2018, while world demand for avocados grew. Many Kenyan coffee farmers switched to Hass avocados. One farmer in Nyeri earned nearly ten times as much from them as from coffee. This is the price mechanism allocating resources: nobody ordered the switch, but farmers moved their land to the crop that now paid more.
The price mechanism works the same way in every market, but a larger market lets sellers from farther away respond to a price change.
A haircut has to be bought where the barber is. Cement is heavy, so it is rarely sent far. Coffee beans travel around the world. So markets come in different sizes.
Local market: a market in which buyers and sellers are in one area, such as a town, because the good cannot easily be bought from or sent to other places.
National market: a market in which buyers and sellers across one country trade a good.
Global market: a market in which buyers and sellers in many countries trade the same good.
Put simply, a market's size is how far apart its buyers and sellers can be and still trade.
The price mechanism works the same way at every size. A shortage raises the price, and the higher price rations the good, signals scarcity and gives sellers a reason to supply more. What changes with size is this:
Two results follow. First, a world price links markets in different countries. In 2024 drought hurt the coffee crop in Brazil, the world's largest grower, so the world supply of coffee decreased. The shortage at the old price pushed the world price of arabica coffee beans up by about 70%. A single grower is almost never big enough to move a world price, but an event that hits a whole country's crop can. The same is true of buyers: a single buyer almost never moves a world price, but a large increase in a whole country's demand can. Coffee became more expensive for buyers in many countries, even in countries that grow none. Growers in other countries also had a reason to plant more.
Second, a local price can jump much further than a price in a larger market, because only nearby sellers can respond. During the 2022 World Cup in Qatar, some one-bedroom flats on the Pearl, an area of Doha, were offered for more than $1,000 a night. Earlier in 2022, rented by the month, apartments on the Pearl cost an average of about $85 a night, so the nightly price was more than ten times as high. Flats cannot be moved to Doha, so only the flats already there could be offered.
Size is not the only factor. How far a price rises also depends on the price elasticity of supply. It measures how much the quantity supplied can respond to a higher price, and how quickly. In Doha the quantity supplied could hardly respond, so the price rose far above its usual level.
Exam Matters: When a question gives a world price, start in the world market. Say which curve the event shifts there and which way the world price moves. Then explain that buyers and sellers in the countries that trade the good face that new price.
There are two types of indirect tax, and each one moves the supply curve in a different way.
When you buy a can of drink, part of the price may go to the government, not to the shop.
Indirect tax: a tax on spending on goods and services, paid to the government by the seller, who may pass some or all of it on to buyers in a higher price.
Put simply, an indirect tax is a tax on what people buy. It is called indirect because the government collects it from the seller, not directly from the buyer. There are two types.
Specific tax: a fixed amount of tax on each unit of a good sold, whatever its price.
Ad valorem tax: a tax charged as a percentage of the price of a good, so the tax on each unit is larger when the price is higher.
The key difference is what happens when the price changes. With a specific tax, the tax on each unit stays the same. With an ad valorem tax, the tax on each unit changes with the price.
Each point on a supply curve shows the price sellers need to receive to supply that quantity. A tax increases the cost of selling each unit. To supply the same quantity as before, sellers now need the original amount plus the tax. This is why the supply curve shifts upwards.
Economists call this a decrease in supply. Although the curve moves up, at every price buyers pay the quantity supplied is now lower. The quantity sold falls in a separate step: the shift raises the price buyers pay, and the higher price reduces the quantity demanded.
Suppose the national government puts a specific tax of $6 on every cooking-gas cylinder sold. In Sabaya's market, sellers now need $6 more whatever the quantity, so every point on the original supply curve, S, moves up by $6. The new curve, S + tax, is parallel to S.
Now suppose the tax is instead 50% of the price sellers need.
Along S, sellers need a higher price for each larger quantity, so the same 50% adds more tax. So the gap between the two curves widens as the quantity rises, and the taxed curve is steeper than S. It pivots away from S instead of moving parallel to it.
Real Example: Saudi Arabia has used both types. Until the end of 2025 it taxed sweetened drinks at 50% of the retail price. That is an ad valorem tax: a more expensive drink paid more tax. Since 1 January 2026 it has charged a fixed amount per litre, set by the sugar content. That is a specific tax: the same whatever the drink's price.
A tax creates a gap between the price buyers pay and the amount sellers keep.
Before a tax, the price on the supply curve is the amount sellers need to receive. After a tax, buyers pay more than that, because part of what they pay goes to the government. So after a tax there are two prices:
Buyers' price − sellers' price = tax. Once you understand this gap, you can read both prices off the diagram. In the exam, always say which price you mean, because after a tax the two are different.
Sabaya's market for cooking-gas cylinders is in equilibrium at $10, with 600 sold a day. Now the national government puts a tax of $6 on every cylinder sold. This shifts supply up to S + tax. The demand curve does not move, because the tax changes nothing that shifts demand, such as income or tastes.
The buyers' price rose by $4, not by $6. Why? As the price buyers pay rises, the quantity demanded contracts. Buyers move along the demand curve, which itself does not move. Sellers can only sell 400 cylinders by accepting less for each one than the $10 they kept before the tax.
If buyers paid the whole tax, they would pay $16. Sellers would keep $10, as before the tax. But at $16 the quantity demanded is only 300, while sellers keeping $10 would supply 600. This surplus (excess supply) of 300 pushes the price down.
The two prices stay $6 apart, so both fall, until buyers pay $14 and sellers keep $8.
So the tax is shared: buyers pay $4 more, and sellers keep $2 less. How it is shared depends on the price elasticity of demand and of supply.
A tax makes consumers and producers worse off and gives the government revenue, but less than the two groups lose.
A tax affects three groups, and its impact is what it does to each of them. Here is the impact of the $6 tax on cooking-gas cylinders in Sabaya:
Tax revenue: the money the government receives from a tax.
The demand curve shows what buyers are willing to pay, and it has not moved, so the higher price reduces consumer surplus. The fall has two parts. Buyers who still buy now pay more, and buyers who stop buying lose the surplus they used to get.
Producer surplus falls in the same two parts. It is measured from S, which still shows the lowest price sellers would accept. Sellers keep $2 less on each of the 400 cylinders still sold, a loss of $800 (UVYZ). On the 200 cylinders no longer sold they lose ½ × $2 × 200 = $200 (VEY).
The rectangles WXVU and UVYZ together make up the revenue rectangle WXYZ, so the $1,600 and $800 that buyers and sellers lose on the cylinders still sold add up to the $2,400 the government receives. But buyers and sellers lose $3,000 a day between them. The other $600, the triangles XEV and VEY, was surplus on the 200 cylinders that are no longer traded. Because those cylinders are no longer bought or sold, no buyer, seller or government receives that surplus, so economists call it a welfare loss.
How much revenue a tax raises depends on how far the quantity sold falls. If supply is the same, the quantity falls only a little when demand is price inelastic, so revenue stays high. When demand is price elastic, buyers switch to other goods, so the quantity falls further and less revenue is raised.
This creates a trade-off. A tax on a harmful good, such as sugary drinks, reduces buying most where demand is price elastic, but that is also where it raises least revenue.
Real Example: In May 2022 Ghana began charging a tax of 1.5% on mobile-money transfers above a daily allowance. That month, the value of mobile-money transactions fell to GH¢71.4 billion, from GH¢87.7 billion in April. Some users switched to cash, which the tax did not cover, so the amount taxed fell. This is how a tax can raise less revenue when people can switch to something untaxed.
Sellers pay a tax to the government, but buyers and sellers usually share its burden.
In Sabaya, sellers send the government $6 for every cooking-gas cylinder they sell. That is their legal duty, but it does not mean they bear the whole $6. To bear a tax means to be made worse off by it. Buyers now pay $14 instead of $10, so they bear part of the tax too.
Tax incidence: the way the burden of a tax is shared between consumers and producers.
Consumer incidence: the part of a tax per unit borne by consumers: the rise in the price they pay.
Producer incidence: the part of a tax per unit borne by producers: the fall in the price they keep.
Put simply, each side bears the change in its own price: buyers bear the rise in the price they pay, and sellers bear the fall in the price they keep. Together the two amounts fill the gap between the two prices, so they always add up to the tax.
On the diagram, W and Z are on the price axis at the two prices after the tax, and X and Y are above the 400 cylinders still sold. The line at the old price, $10, runs from U on the price axis through V to E, the old equilibrium, and splits the revenue rectangle WXYZ. The buyers' share, WXVU, is above the line, and the sellers' share, UVYZ, is below it. Incidence counts only the 400 cylinders still sold, so buyers' $1,600 and sellers' $800 are smaller than their falls in surplus, $2,000 and $1,000, which also include the triangles XEV and VEY.
Two words in this topic are easy to mix up:
Each side can avoid part of a tax by trading less: buyers by buying less, and sellers by selling less. The side that can do this more easily pushes more of the tax onto the other, and price elasticity measures how easily. So the more price elastic side bears less of the tax, and the less price elastic side bears more.
When demand is less price elastic than supply, the quantity demanded hardly falls as the price rises, so sellers can charge buyers most of the tax. When demand is more price elastic than supply, buyers switch to other goods as the price rises. A higher price would leave a surplus, so sellers must accept a lower price and bear more.
Supply works the same way. Goods that are already made and cannot be stored have supply that is less price elastic than demand, so sellers must accept a lower price to sell them and bear more. When supply is more price elastic than demand, the quantity supplied falls a lot as soon as the price sellers keep falls. The smaller quantity then raises the price buyers pay, so buyers bear more.
In these extreme cases one side's price stays at its level before the tax, so the other side bears the whole tax.
How many goods a tax covers matters too. A tax on almost everything leaves nothing untaxed to switch to, so buyers cannot easily avoid it: demand is less price elastic, and buyers bear more. A tax on one good with untaxed substitutes makes demand for that good more price elastic, so its sellers bear more.
Over time, buyers find substitutes and sellers move their resources into other goods, so both sides become more price elastic. The side whose price elasticity rises more ends up bearing less of the tax.
Real Example: In almost every US state, licensed wholesalers, not smokers, pay the cigarette tax to the government. Yet a study of 2006 and 2007 found that smokers bore about 85% of it on average. Near a border with a lower-tax state, where smokers could buy in the next state, they bore only about half. So who bears a tax depends on how easily buyers can avoid it, not on who pays the government.
A subsidy works like a tax in reverse: it lowers the price buyers pay and raises the quantity sold.
Sometimes a government wants people to buy more of a good, such as cooking gas instead of firewood. One way is to pay sellers for every unit they sell.
Subsidy: a payment by the government to producers for each unit of a good they produce or sell, which lowers their costs and increases supply.
Put simply, sellers receive an extra amount from the government for every unit they sell, in addition to what the buyer pays. For sellers, this works like a fall in their costs.
Here is the $6 tax on cooking-gas cylinders in Sabaya beside a subsidy of $3 a cylinder, paid to sellers by the national government. Each change has a mirror image:
With the subsidy, $3 of the price sellers need for each quantity comes from the government, so they need $3 less from the buyer. The supply curve shifts down by $3, to S − subsidy: an increase in supply. The demand curve does not move, because the subsidy changes nothing that shifts demand, such as income or tastes.
At the old price, $10, sellers now receive $10 from the buyer and $3 from the government, $13 in all. At $13, S shows a quantity supplied of 900, while the quantity demanded is still 600. This surplus (excess supply) of 300 pushes the price buyers pay down, and as it falls, buyers move along the same demand curve.
So after a subsidy, sellers receive more than buyers pay, and the gap is the subsidy. After a tax, buyers pay more than sellers keep, and the gap is the tax.
Both surpluses rise, and each rise has two parts: a gain on the 600 cylinders already traded, and a gain on the 100 extra.
Cost of a subsidy: the total amount the government spends on a subsidy.
For the same subsidy per unit, the more price elastic demand and supply are, the more extra units are sold, and the more the subsidy costs. The money also has an opportunity cost: it could have paid for other public spending, lower taxes or less borrowing.
Real Example: In August 2020 the UK government paid half the price of meals eaten out on Mondays to Wednesdays, up to £10 a person. The Treasury expected this to cost about £500 million. Diners ate more than 160 million discounted meals, and restaurants claimed £849 million. The cost was far above the estimate. This is how a subsidy, which is paid on every unit sold including the extra units it brings, can cost more than planned.
A subsidy is paid to sellers, but buyers gain from it too, through a lower price.
The national government pays sellers $3 for every cooking-gas cylinder sold in Sabaya. To see who gains, compare each price with the price before the subsidy, $10.
Incidence of a subsidy: the way the benefit of a subsidy is shared between consumers and producers.
Put simply, the subsidy is split into a lower price for buyers and a higher price for sellers, so sellers do not gain the whole $3. The two parts always add up to the subsidy per unit, because together they fill the gap between the two prices.
On the diagram, M and T are on the price axis at the two prices with the subsidy, and N and R are above the 700 cylinders sold. The line at the old price runs from G on the price axis to H and cuts the cost rectangle MNRT. The buyers' share, GHRT, is below the line, and the sellers' share, MNHG, is above it. The rises in consumer and producer surplus, $1,300 and $650, are a little smaller than these shares, $1,400 and $700, because on the 100 extra cylinders each side gains less than the full $2 or $1.
The subsidy creates a surplus (excess supply) at the old price, and the price buyers pay falls until it is gone. If demand is much less price elastic than supply, the quantity demanded rises only a little as the price falls. So the price must fall a lot, and buyers gain most of the subsidy.
If supply is much less price elastic than demand, the subsidy adds little to the quantity supplied at the old price, so the surplus is small. The price buyers pay hardly falls, and sellers gain most of the subsidy.
In Sabaya, buyers gain $2 of the $3 and sellers gain $1. Start from $10 and 600 cylinders. A $1 change in price moves the quantity demanded by 50, but it moves the quantity supplied by 100. So demand is less price elastic than supply here, and buyers gain more.
So who gains depends on the price elasticities of demand and supply, not on who the government pays.
Real Example: From 2013, England's Help to Buy scheme gave cheap loans to buyers of new-build homes, not to sellers, so it increased demand rather than supply. The same rule still decided who gained. In London, new-build prices rose by about 6% and few extra homes were built, so supply was price inelastic and sellers gained. Near the Welsh border, more homes were built and prices did not rise, so supply was price elastic and buyers gained.
To judge a subsidy, weigh the benefit to the people it is meant to help against its cost.
A diagram shows what a subsidy does. Whether it is worth having is a judgement, and it starts with one question: what is the subsidy for? Each aim has its own test, so the verdict on the $3 subsidy for cooking-gas cylinders in Sabaya depends on the aim.
To evaluate a subsidy against its aim, answer these questions and say what each answer depends on.
Targeted subsidy: a subsidy paid only to chosen groups, such as low-income households or small farmers, rather than to everyone who buys or sells the good.
Put simply, a targeted subsidy goes only to the people the government wants to help. The government does not pay on units bought by anyone else, so it can help those people for less.
Real Example: From 2020, Malawi's Affordable Inputs Programme offered 3.8 million farming households cheap fertiliser to raise food output, and with good rains the harvest was large. But the programme cost over 1.5% of the value of everything Malawi produced in a year. Researchers argued that targeting the farmers who use fertiliser best could keep similar output for less. This is how a subsidy offered to millions of households can be very expensive for the government.
At the equilibrium price, the quantity buyers want to buy equals the quantity sellers want to sell.
On a diagram, the equilibrium is where the demand and supply curves cross, giving both a price and a quantity.