1.2.7 Price Mechanism Flashcards
What is the price mechanism?
> In a free market economy, the price mechanism allocates resources. The economic problem of scarce resources can be solved with this mechanism.
Price is determined by the interactions of demand and supply which also determines how much is bought and sold and by whom.
The price moves resources to where they are demanded or where there is a shortage, and removes resources from where there is a surplus.
Functions of the price mechanism:
> Rationing Function - the price system can ration goods because when price increases, some people will no longer be able to buy the product and others may no longer desire the good. It reduces demand. The limited resources can then be rationed and allocated to the people who can afford the good and those that value them most highly.
Signalling Function - the price mechanism acts as a signal where resources should be used. When prices rise, producers move resources into the manufacture of that product.
The change in price indicates to suppliers and consumers that market conditions have changed so they should change the quantity bought and sold. When price equilibrium moves, output equilibrium moves with it.
Incentive Function - prices act as an incentive for buyers and sellers. The price mechanism encourages people to behave in a certain way. A low price is an incentive for buyers to buy more of a good, and a high price acts as an incentive to suppliers to sell more of a good.
The price mechanism in context of local markets:
The coronavirus pandemic originally disrupted supply chains across the planet. For British supermarkets, this means there are less goods on the shelves due to less imports. As demand for these goods is high but supply was low, the price of food rises to ration off excess demand so that only the consumers that value the good most can buy them.
In context of a National market:
> The price of housing differs across the UK. As the population of London is high relative to the rest of the UK, house prices will rise through the rationing function. Therefore houses will only be provided to those who value them most.
The high house prices also offer an incentive for firms to allocate resources to the production of more houses, as there is profit to be made in this industry.
In context of a global market:
In 1973 OPEC proclaimed an oil embargo. This sent the price of oil at record breaking levels. This exemplifies the rationing function, because the disequilibrium between supply and demand meant the high prices deterred consumers who didn’t value oil highly, leaving the market open only to those who did. Raising the price allowed the market to return to equilibrium.
