IB Analysis Practice

Definition: A price ceiling (maximum price) is a legally imposed maximum price that producers can charge, set below the free-market equilibrium price. It is typically implemented to make essential goods affordable for consumers (e.g. rent controls, food price caps).

Step 1: In a free market, equilibrium is determined where demand equals supply, giving equilibrium price Pe and quantity Qe. At Pe, the market clears — there is no excess demand or supply.

Step 2: When the government sets a price ceiling (Pmax) below Pe, the lower price increases the quantity demanded — consumers want to buy more at the cheaper price (movement along the demand curve from Qe to Qd). This is because more consumers can now afford the good, and existing consumers may want to buy larger quantities.

Step 3: Simultaneously, the lower price reduces the quantity supplied — producers are less willing and able to supply at the lower price because it may not cover their costs of production (movement along the supply curve from Qe to Qs). Some firms may exit the market if the price is below their average variable cost.

Step 4: The result is excess demand (a shortage) equal to Qd − Qs. This shortage means some consumers who are willing and able to pay Pmax cannot obtain the good. This may lead to non-price rationing mechanisms such as queuing, black markets (where the good is sold illegally above Pmax), or favouritism.

Diagram: A standard demand-supply diagram should be drawn showing: Pe, Qe at equilibrium; Pmax below Pe; Qd and Qs at Pmax; and the shortage labelled as the gap between Qd and Qs.

Definition: Economic growth is an increase in real GDP over a period of time. Government spending (G) is a component of aggregate demand (AD = C + I + G + (X − M)). Fiscal policy refers to the use of government spending and taxation to influence the level of economic activity.

Step 1: An increase in government spending (e.g. on infrastructure, healthcare, or education) directly increases a component of AD, shifting the AD curve to the right from AD to AD₁.

Step 2: On a Keynesian AS diagram, if the economy is operating in the spare-capacity region (horizontal section of AS), the rightward shift of AD leads to an increase in real GDP from Y₁ to Y₂ with little or no increase in the price level. This represents actual economic growth.

Step 3: The increase in real GDP means higher output, more employment, and rising incomes. Workers who gain employment spend their income on goods and services, creating additional demand — this is the multiplier effect. The final increase in GDP is greater than the initial increase in government spending.

Step 4: However, if the economy is near full capacity (the steep section of the Keynesian AS curve), the increase in AD leads primarily to a rise in the price level rather than real GDP growth — this is demand-pull inflation. The effectiveness of government spending in promoting growth therefore depends on the existing level of spare capacity in the economy.

Definition: Perfect competition is a market structure characterised by many small firms, homogeneous products, perfect information, and no barriers to entry or exit. Normal profit is the minimum profit necessary to keep a firm in the industry — it is included in the cost curves as a cost of production.

Step 1: In the short run, a perfectly competitive firm may earn supernormal (abnormal) profit if the market price (P) is above average total cost (ATC). The firm is a price taker (perfectly elastic demand/AR/MR curve) and maximises profit at MC = MR.

Step 2: Because there are no barriers to entry, the existence of supernormal profit attracts new firms into the industry. As new firms enter, the total market supply increases, shifting the market supply curve to the right.

Step 3: The increase in market supply drives down the market price. The individual firm's perfectly elastic demand curve shifts downward. This process continues as long as supernormal profit exists — new entrants keep joining and pushing the price lower.

Step 4: Long-run equilibrium is reached when the market price has fallen to the point where P = AR = MR = MC = minimum ATC. At this point, firms earn only normal profit — there is no incentive for further entry or exit. This is both allocatively efficient (P = MC) and productively efficient (producing at minimum ATC).

Definition: Depreciation is a fall in the value of a currency in a floating exchange rate system. The current account records trade in goods and services, primary income, and secondary income. A current account deficit exists when debits (imports, income outflows) exceed credits (exports, income inflows).

Step 1: A depreciation makes exports cheaper in foreign currency terms. For example, if the pound depreciates against the dollar, a British good priced at £100 costs fewer dollars for American buyers. This increases the quantity demanded of exports — the country becomes more price competitive internationally.

Step 2: Simultaneously, imports become more expensive in domestic currency terms. Foreign goods now cost more for domestic consumers, reducing the quantity demanded of imports. Consumers may switch to domestically produced substitutes.

Step 3: The combined effect of rising export revenue and falling import expenditure should improve the current account balance (reduce a deficit or increase a surplus). However, this is conditional on the Marshall-Lerner condition: the sum of PED for exports and PED for imports must be greater than 1 for depreciation to improve the current account.

Step 4: In the short run, the J-curve effect may operate — existing trade contracts are fixed in foreign currency, so the value of imports initially rises (as more domestic currency is needed to pay the same foreign currency price), worsening the current account before volumes adjust. Improvement occurs in the medium to long run as new contracts are negotiated and quantities respond to changed relative prices.