Price Mechanism Flashcards
What is the price mechanism?
The price mechanism is the means by which decisions of consumers and businesses interact to determine the allocation of resources.
The free market price mechanism clearly does not ensure an equitable distribution of resources and can lead to market failure
Changes in market prices
Changes in market prices act as a signal about how scarce resources should be allocated
A rise in price encourages producers to switch into making that hood but encourages consumers to use an alternative substitute product (therefore rationing the product)
A fall in price leads to an extension of demand but makes it less profitable for a business to supply the good or service affected.
Signalling function
Prices perform a signalling function - i.e. they adjust to demonstrate where resources are required
Prices rise and fall to reflect scarcities and surpluses.
If prices are rising because of high demand from consumers, this is a signal to suppliers to expand production to meet the higher demand.
If there is excess supply in a market, the price mechanism will help to eliminate a surplus of a good by allowing the market price to fall.
Incentive function
Through choices consumers send information to producers about their changing nature of needs and wants.
One important feature of a free market system is that decision making is decentralised, i.e. there is no single body for deciding what to produce and in what quantities.
This is in contrast to a panned (state controlled) economic system where there is a significant intervention in market prices and state ownership of key industries
Rationing function
Prices ration scarce resources when demand is much greater than supply
When there is a shortage, price is bid up - leaving only those with willingness and ability to pay to buy.
Equilibrium price
Equilibrium means a state of equality between demand and supply
The equilibrium price in a market is known as the market clearing price.
- At this price there is no excess demand or excess supply
- The quantity that producers wish to sell equals the quantity that consumers are willing and able to buy at that price.
Excess demand
Excess supply
The concept of the equilibrium price
- Without a shift in demand or supply there will be no change in market price
- Changes in the conditions of demand or supply will shift demand or supply curves. This will cause changes in the equilibrium rice and quantity in the market.
The rationing function
