1.2.7 Price mechanism Flashcards
Price mechanism
In a free market economy, the price mechanism allocates resources. Price is determined by the interactions of demand and supply, which also determines how much is bought and sold and by whom. Prices rise when buyers want to purchase more than suppliers want to sell, encouraging suppliers to sell more as they will be able to make a higher profit. Adam Smith described the ‘invisible hand’ of the market, how the price mechanism is able to set prices.
Functions of the price mechanism to allocate resources
The rationing function
The signalling function
The incentive function
Rationing function of price mechanism
The price system is a way of rationing goods because when price increases, some people will no longer be able to afford to buy the product and others may no longer have the desire the buy the good. The limited resources can be rationed and allocated to the people who are able to afford them and those who value them most highly.
Signalling function of price mechanism
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 of price mechanism
It acts as an incentive for people to work hard. Buyers realise that the more money they have, they are able to buy more products.
Suppliers realise that if they produce more of the goods, they will make more money.
Also, low prices act as an incentive for consumers to buy more of a good and high prices act as an incentive to suppliers to sell more of a good.
- The price mechanism encourages people to behave a certain way.
The price mechanism in the context of different types of markets: Local market rationing function example
The coronavirus pandemic has disrupted supply chains across the planet, and many countries have blocked imports to prevent the spread of the virus.
If we take the example of British supermarkets, less imports from other countries means there are fewer goods on supermarket shelves.
As the demand for food is high but the supply is low, the price of food rises to ration off the excess demand so that only the consumers who value the food most highly buy them.
- This is an example of the rationing function.
The price mechanism in the context of different types of markets: National market rationing and incentive function
1) The price of housing differs across the UK, from being high in the south and low in the north.
There are multiple reasons to explain these discrepancies: e.g. London, not only the capital, is the second largest financial centre in the world, as well as home to many tourist attractions. As the population of London is high relative to the rest of the UK, house prices will rise through the rationing function, i.e. to ration off excess demand and only provide houses to those who value them the most.
- Rationing function
2) The high house prices in London 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.
- This is an example of the incentive function.
The price mechanism in the context of different types of markets: Global market
In 1973 the Organisation for Petroleum Exporting Countries (OPEC) proclaimed an oil embargo (i.e. restricted the supply of oil on an insurmountable scale), due to geopolitical factors regarding America and the Middle East.
This sent the price of oil at record-breaking levels across the planet, as oil was an invaluable resource to countries.
- This perfectly exemplifies the rationing function because the disequilibrium of supply and demand meant the high prices deterred consumers who didn’t value oil highly, which left the market open only to those consumers who did.
-By raising the price of oil, the market once again returned to a state of equilibrium.
