10- The Price Mechanism

Question 1

What does the price mechanisms do?

Answer 1

They allocate resources between conflicting uses.

Question 2

What helps determine price?

Answer 2

The interactions of supply and demand. Which also determine how much is bought and sold by whom.

Question 3

What are the 3 functions price has in allocating resources (price mechanism)?

Answer 3

• Rationing function
• Signalling function
• Incentive function

Question 4

What is involved in the rationing function?

Answer 4

• Prices rationed to reach market equilibrium
• e.g. if consumers demand a good and supply is relatively scarce, prices will be high to ration the excess demand
  If demand is low and supply is relatively high then prices will be low. The low prices reflect the scarcity of the good.

Question 5

What is involved in the signalling function?

Answer 5

• The Price of a good is a key piece of information to buyers and sellers in the market. They act as a signal to the market.
• Decisions about buying and selling are based on these signals
• The change in prices signals to both buyers and sellers should change quantity bought and sold
• Suppliers are incentivised by high prices to supply and consumers will consume less at a higher price

Question 6

What is involved in the incentive function?

Answer 6

• Price acts as an incentive for buyers and sellers.
• Low prices encourage buyers to purchase more goods. This is because the amount of utility gained per pound spent increases relative to other goods
• And higher prices discourage buyers to consume
• High prices encourage suppliers to supply and low prices discourage production

Question 7

Contribution per unit definition

Answer 7

Contribution per unit of a product is the difference between the selling price of the product and the variable cost.

Question 8

Variable cost definition

Answer 8

The variable cost of a product are the costs that change as output increases
E.g. the cost of raw materials used to make a good

Question 9

Allocative efficiency definition

Answer 9

Occurs where consumer satisfaction is maximised in the production of goods and services. At this point the quantity supplied will be equal to the quantity demanded (market equilibrium)

Question 10

Productive efficiency definition

Answer 10

Occurs when no additional (or maximum) output can be produced from the factor inputs available at the lowest possible average or unit cost

Question 11

Economic efficiency definition

Answer 11

Occurs when we have allocative and productive efficiency at the same time.

Question 12

How do competitive markets help achieve allocative efficiency?

Answer 12

As market forces push prices towards equilibrium (Which is allocative efficient)