ECS2601
Assignment 1
Semester 1
Due 19 March 2026
,1. MARKET MECHANISM AND CORE CONCEPTS
1.1 How the market mechanism works and how price adjust-
ments eliminate shortages and surpluses (2)
The market mechanism operates through the interaction of buyers and sellers, where
prices serve as signals that coordinate economic decisions (Mankiw, 2021). When de-
mand exceeds supply at a given price, a shortage occurs, creating upward pressure on
prices. As prices rise, producers increase output while consumers reduce purchases until
equilibrium is restored. Conversely, when supply exceeds demand, a surplus develops,
forcing sellers to lower prices. Lower prices stimulate demand and discourage produc-
tion, eliminating the surplus.
S
Price
P1
P0
Qs Qd
D
Quantity
Figure 1: Market Adjustment Process: At price P0 (below equilibrium), quantity de-
manded (Qd ) exceeds quantity supplied (Qs ), creating a shortage. Competition among
buyers pushes prices toward equilibrium P1 .
1
, 1.2 Differentiate between substitution effect and income effect
(4)
The substitution effect occurs when consumers replace a relatively expensive good
with a cheaper alternative following a price change, holding real purchasing power con-
stant. For instance, if the price of chicken falls while beef prices remain unchanged,
consumers will substitute chicken for beef because chicken now offers better value (Var-
ian, 2014).
The income effect captures how a price change alters consumers’ real purchasing
power. When chicken prices fall, consumers can buy the same basket of goods for less
money, effectively increasing their real income. For normal goods, this reinforces in-
creased consumption; for inferior goods, it may reduce consumption despite the lower
price (Mankiw, 2021).
Good Y
A
Substitution
B
Income
C
I2
I1
BL1 Good
BL2 X
Figure 2: Decomposition of Price Effect: Moving from A to B shows the substitution
effect (same utility, different relative prices). Moving from B to C shows the income
effect (higher purchasing power). The total effect A to C combines both.
2
Assignment 1
Semester 1
Due 19 March 2026
,1. MARKET MECHANISM AND CORE CONCEPTS
1.1 How the market mechanism works and how price adjust-
ments eliminate shortages and surpluses (2)
The market mechanism operates through the interaction of buyers and sellers, where
prices serve as signals that coordinate economic decisions (Mankiw, 2021). When de-
mand exceeds supply at a given price, a shortage occurs, creating upward pressure on
prices. As prices rise, producers increase output while consumers reduce purchases until
equilibrium is restored. Conversely, when supply exceeds demand, a surplus develops,
forcing sellers to lower prices. Lower prices stimulate demand and discourage produc-
tion, eliminating the surplus.
S
Price
P1
P0
Qs Qd
D
Quantity
Figure 1: Market Adjustment Process: At price P0 (below equilibrium), quantity de-
manded (Qd ) exceeds quantity supplied (Qs ), creating a shortage. Competition among
buyers pushes prices toward equilibrium P1 .
1
, 1.2 Differentiate between substitution effect and income effect
(4)
The substitution effect occurs when consumers replace a relatively expensive good
with a cheaper alternative following a price change, holding real purchasing power con-
stant. For instance, if the price of chicken falls while beef prices remain unchanged,
consumers will substitute chicken for beef because chicken now offers better value (Var-
ian, 2014).
The income effect captures how a price change alters consumers’ real purchasing
power. When chicken prices fall, consumers can buy the same basket of goods for less
money, effectively increasing their real income. For normal goods, this reinforces in-
creased consumption; for inferior goods, it may reduce consumption despite the lower
price (Mankiw, 2021).
Good Y
A
Substitution
B
Income
C
I2
I1
BL1 Good
BL2 X
Figure 2: Decomposition of Price Effect: Moving from A to B shows the substitution
effect (same utility, different relative prices). Moving from B to C shows the income
effect (higher purchasing power). The total effect A to C combines both.
2
