1.2.7 Price mechanism

Question 1

What are the 3 functions of the price mechanism

Answer 1

Signalling, rationing and incentive are the the 3 functions in the price mechanism in allocating resources

Question 2

Explain the signalling function

Answer 2

Price acts as a signal for producers as it reflects consumer preferences. For example if price rises due to demand increasing it signals to producers to increase their output in order to maximise profits. The shift in demand causes movement along the supply curve hence firms responding to the signal through their output. Price can also signal areas in markets of rationing and surpluses as price falls = surpluses and price rises = rartioning

Question 3

Explain the incentive function

What will it depend on

Answer 3

The incentive function leads on from the signalling function as when firms are signalled through changes in price for e.g. higher prices this will incentivise firms to output more although depends on the marginal cost. If the MC is higher than the price than it will not be profitable thus firms should rationally decide to not to increase output however if the price rises to higher than the MC than producing the extra unit will lead to higher profits.

Question 4

Explain the rationing function

Answer 4

When demand for goods are high, prices increase in order to meet a new equilibrium price and when goods become increasingly scarce prices rise so that only those who are willing and able to buy the goods can meaning scarce resources become rationed