What happens at a price above equilibrium?

Excess supply (surplus): firms cut prices until the market clears.

Three functions of price in a market?

Signalling (information), incentive (motivation to change behaviour) and rationing (allocating scarce goods).

Define producer surplus.

The difference between the price firms receive and the minimum they would accept; the area above supply and below price.

(HL) How do you find equilibrium from linear functions?

Set $Q_d = Q_s$, solve for $P$, then substitute $P$ into either function to get $Q$.

Economics

2.3 Competitive market equilibrium

Q: Define consumer surplus.

The difference between what consumers are willing to pay and what they actually pay; the area below demand and above price.

A competitive market settles where demand meets supply, and prices move to remove shortages and surpluses while signalling, rationing and creating incentives. Study guide, 4 practice questions with markschemes and 5 flashcards. Free.

Equilibrium price and quantity · shortages and surpluses · signalling, incentive and rationing functions of price · consumer and producer surplus · social surplus and allocative efficiency · (HL) calculating equilibrium from linear functions

Practise all 4 questions Study 5 flashcards

Study guide

Equilibrium

Equilibrium occurs at the price where quantity demanded equals quantity supplied, so there is no pressure for change. Diagram in words: P on the vertical axis, Q on the horizontal, D sloping down, S sloping up, crossing at equilibrium price Pe and quantity Qe.

If price is above Pe, quantity supplied exceeds quantity demanded: a surplus (excess supply). Firms cut prices to sell stock, and price falls back to Pe.
If price is below Pe, quantity demanded exceeds quantity supplied: a shortage (excess demand). Buyers compete, sellers raise prices, and price rises to Pe.

When demand or supply shifts, a new equilibrium forms. Always show the old and new equilibrium price and quantity on the diagram.

The three functions of price

Signalling: a price change sends information. A rising price tells producers consumers want more of the good.
Incentive: a higher price motivates firms to produce more because it can raise profit, and motivates consumers to use less.
Rationing: when a good is scarce, the price rises until only those willing and able to pay that price buy it, sharing out the limited quantity.

Together these show how a free market reallocates resources without central planning, an idea often called the price mechanism.

Consumer and producer surplus

Consumer surplus is the difference between what consumers are willing to pay and what they actually pay. On the diagram it is the area below the demand curve and above the price, out to the quantity traded.

Producer surplus is the difference between the price producers receive and the lowest price they would accept (their marginal cost). It is the area above the supply curve and below the price.

Social (community) surplus is the sum of the two. In a competitive market with no externalities, social surplus is maximised at equilibrium. This is allocative efficiency: resources produce the mix of goods society values most, where marginal benefit (MB) = marginal cost (MC). Since the demand curve reflects MB and the supply curve reflects MC, equilibrium meets this condition.

(HL) Calculating equilibrium and surplus

Set $Q_d = Q_s$ and solve.

Worked example (HL): $Q_d = 150 - 5P$ and $Q_s = -30 + 10P$.

$150 - 5P = -30 + 10P \Rightarrow 180 = 15P \Rightarrow P = 12$.
$Q = 150 - 60 = 90$. Check: $-30 + 120 = 90$.
Demand meets the price axis where $Q_d = 0$: P = 30. Supply meets it where $Q_s = 0$: P = 3.
Consumer surplus $= \frac{1}{2} \times 90 \times (30 - 12) = 810$.
Producer surplus $= \frac{1}{2} \times 90 \times (12 - 3) = 405$.
Social surplus $= 1215$.

If price were held at 10: $Q_d = 100$, $Q_s = 70$, so there is a shortage of 30 units.

Common mistakes

Labelling the vertical intercept triangle as consumer surplus without stopping at the quantity traded.
Explaining a shortage with "demand increases". Price below equilibrium raises quantity demanded, not demand.
Assuming market equilibrium is always efficient. It is only allocatively efficient when there are no externalities or other failures (see 2.8).

Exam tips

10-mark questions: explain the price mechanism with a diagram showing a shift, the temporary shortage or surplus, and the move to the new equilibrium. Name all three functions of price and link each to the context.
15-mark questions: evaluate whether markets allocate resources well. Credit efficiency and decentralised information, then discuss equity (rationing by ability to pay), externalities, information gaps and market power.
HL calculations: write down both intercepts before finding surplus areas; area of a triangle is half base times height.

Cheat sheet

Equilibrium: $Q_d = Q_s$
P > Pe → surplus = $Q_s - Q_d$ · P < Pe → shortage = $Q_d - Q_s$
Functions of price: signalling, incentive, rationing
CS = area under D, above price · PS = area above S, below price
Triangle area = $\frac{1}{2} \times$ base $\times$ height
Social surplus = CS + PS, maximised at competitive equilibrium (MB = MC)
HL steps: solve for P, substitute for Q, find both price intercepts, compute CS and PS
Diagram checklist: D, S, Pe, Qe, shaded CS above price, shaded PS below price

Key definitions

Market equilibrium: The price and quantity at which quantity demanded equals quantity supplied.
Surplus (excess supply): The amount by which quantity supplied exceeds quantity demanded at a price above equilibrium.
Shortage (excess demand): The amount by which quantity demanded exceeds quantity supplied at a price below equilibrium.
Signalling function: The role of price in conveying information to buyers and sellers about changing conditions.
Incentive function: The role of price in motivating producers and consumers to change their behaviour.
Rationing function: The role of price in distributing scarce goods to those willing and able to pay.
Consumer surplus: The difference between the highest price consumers are willing to pay and the price they actually pay.
Producer surplus: The difference between the price producers receive and the lowest price they would accept.
Allocative efficiency: An allocation of resources where marginal benefit equals marginal cost, maximising social surplus.

Practice questions

HLPaper 3Challenging

Question 1

The daily market for fresh juice in a city is described by $Q_d = 200 - 10P$ and $Q_s = -40 + 20P$, where $P$ is in dollars and $Q$ in litres.

(a) [2]

Calculate the equilibrium price and quantity.

Markscheme

1 $200 - 10P = -40 + 20P \Rightarrow P = 8$
1 $Q = 120$

(b) [2]

Calculate consumer surplus at equilibrium.

Markscheme

1 Demand meets the price axis at $P = 20$
1 $CS = \frac{1}{2} \times 120 \times (20 - 8) = 720$

(c) [2]

Calculate producer surplus at equilibrium.

Markscheme

1 Supply meets the price axis at $P = 2$
1 $PS = \frac{1}{2} \times 120 \times (8 - 2) = 360$

(d) [2]

If the price were $6, calculate the size of the shortage.

Markscheme

1 $Q_d = 140$, $Q_s = 80$
1 Shortage = 60 units

SLPaper 1Challenging

Question 2

(a) [10]

Explain how the signalling and incentive functions of price help to allocate resources in a free market.

Markscheme

1 Defines the key economic terms used in the question accurately
2 Accurate diagram showing an increase in demand, a temporary shortage and a new higher equilibrium
2 Explains the signalling function: a rising price tells producers and consumers that the good has become scarcer or more wanted
2 Explains the incentive function: higher price motivates firms to increase quantity supplied and new resources to move into the industry
2 Explains how the reverse happens when price falls, so resources move out
1 Uses a real-world example, e.g. rising demand for electric bikes

(b) [15]

Evaluate the view that the price mechanism always leads to an efficient allocation of resources.

Markscheme

1 Defines allocative efficiency (MSB = MSC, social surplus maximised)
2 Diagram showing that competitive equilibrium maximises consumer plus producer surplus
3 Explains why competitive markets can achieve allocative efficiency when there are no external effects
2 Uses at least one real-world example
2 Evaluates: externalities mean MPB/MPC differ from MSB/MSC, so output is not optimal
2 Evaluates: public goods, asymmetric information or market power cause further failure
2 Evaluates: efficiency does not guarantee equity; the outcome depends on income distribution
1 Reaches a supported conclusion

SLPaper 2Standard

Question 3

Extract: Tickets gone in minutes

All 15,000 tickets for the band Northern Lights' stadium show sold out in four minutes at a fixed price of $80. Within an hour, tickets were offered on resale sites for up to $310. Many fans complained they had waited online and got nothing.

(a) [2]

Define the term excess demand.

Markscheme

1 Quantity demanded is greater than quantity supplied
1 at a price below the equilibrium price

(b) [4]

Using a demand and supply diagram, explain why the tickets sold out and resale prices were much higher than $80.

Markscheme

1 Diagram with vertical (perfectly inelastic) supply at 15,000 tickets
1 Price of $80 shown below the equilibrium price
1 Shortage identified as the gap between quantity demanded and 15,000
1 Explains that buyers unable to get tickets are willing to pay above $80, so resale prices rise towards the market-clearing level

(c) [2]

Explain the rationing function of price, with reference to the extract.

Markscheme

1 When price rises it reduces quantity demanded so that scarce goods go to those willing and able to pay most
1 At $80 price could not ration the tickets, so they were allocated by queueing or luck instead

Key facts

What happens at a price above equilibrium?: Excess supply (surplus): firms cut prices until the market clears.
Three functions of price in a market?: Signalling (information), incentive (motivation to change behaviour) and rationing (allocating scarce goods).
Define consumer surplus.: The difference between what consumers are willing to pay and what they actually pay; the area below demand and above price.
Define producer surplus.: The difference between the price firms receive and the minimum they would accept; the area above supply and below price.
(HL) How do you find equilibrium from linear functions?: Set $Q_d = Q_s$, solve for $P$, then substitute $P$ into either function to get $Q$.