1.2 - Price mechanism

Question 1

What 3 functions does the price mechanism fulfil?

Answer 1

• Rationing
• Signalling
• Incentive

Question 2

Explain the rationing function of the price mechanism

Answer 2

• Prices allocate (ration) scarce resources
• when resources become scarcer the price rises further
• this limits the good to those who can afford it

Question 3

Explain the signalling function of the price mechanism

Answer 3

• provides information to producers and consumers where resources are required (in markets where prices increase) and where they are not (in markets where prices fall)
• indicates to consumers and producers that market conditions have changed so they should change the quantity bought and sold

Question 4

Explain the incentive function of the price mechanism

Answer 4

• When prices of a good/service rise,
• it incentivises producers to reallocate resources from a less profitable market to this market (enter) in order to maximise profits.
• it incentivises consumers to work harder to be able to afford the good/service
  -low peices incentivise consumers to consume the good.