1.2.7 Price mechanism Flashcards
What are the conditions for a competitive market?
- There are a large number of buyers and sellers (consumers and producers).
- No single consumer or producer can influence the allocation of resouces by the market, or the price that goods and services can be bought at.
How do consumers and producers act rationally?
- Consumers aim to maximise their welfare by buying goods/services to maintain or improve their quality of life.
- Producers compete to provide consumers with what they want at the lowest possible price – so they can maximise their profit by selling to the most customers.
What is the main way of allocating resouces in a free market economy?
Price
What is the price mechanism?
The means by which decisions taken by consumers and businesses interact to determine the allocation of resources. It ensures that an equilibrium point is reached between supply and demand
How does the price mechanism allocate resources in a free market?
Prices change until an equilibrium is achieved and supply equals demand.
It therefore determines how expensive something is, therefore influencing whether someone buys it and how much of it a producer supplies.
Give an advantage of the price mechanism
Goods are allocated in an impersonal way (known as the invisible hand).
This means it is free from people’s biases and opinions.
What are the three functions of the price mechanism?
- Incentive function: Changing prices acts as an incentive to firms.
- Signalling function: Changing prices send messages to consumers and producers about whether to enter or leave a market.
- Rationing function: Where demand is greater than supply, supply needs to be rationed to reach an equilibrium.
Advantages of the price mechanism
- Resources will be allocated efficiently to satisfy consumers’ wants and needs.
- The price mechanism can operate without the cost of employing people to regulate it.
- Consumers decide what is and isn’t produced by producers.
- Prices are kept to their minimum as resources are used as efficiently as possible.
Disadvantages of the price mechanism
- Inequality in wealth and income is likely.
- There will be an under-provision of merit goods and an over-provision of demerit goods, as the supply of and demand for these goods won’t be at the socially optimal level.
- People with limited skills or ability to work will suffer unemployment or receive very low wages.
- Public goods won’t be produced.
Incentive function
- Higher prices allow firms to produce more goods/services and encourage increased production and sales, providing higher profits.
- When demand decreases (shift to left), supply contracts as producers are less incentivised to make profit at the new lower rate.
Associated with extension/contraction along the supply curve.
Is decision making in a free market centralised?
No - a key feature of a free-market system is that decision-making is decentralised, i.e. there is no single body responsible for deciding what to produce and in what quantities.
This is in contrast to a planned (state-controlled) economic system where there is significant intervention in market prices and state-ownership of key industries.
Signalling function
- Rising prices give a signal to consumers to reduce demand or withdraw from a market completely, and they give signal to potential suppliers to enter a market.
- Falling prices give a positive message to consumers to enter a market while sending a negative signal to producers to leave a market.
Associated with shifts in either the supply or demand curves.
Rationing function
- If there is a high demand for a good/service and supply is limited, then the price will be high. Supply of the good will be restricted to those who can afford to pay a high price.
-The opposite also applies for goods that are in low demand but in high supply – they’ll have a low price, and many will be sold.
An example of how the rationing function can be seen in auctions. E.g. eBay
Associated with extension/contraction along the demand curve.
