1.2.7 Price mechanism

Question 1

How did Adam Smith describe the invisible hand?

Answer 1

Adam Smith described the invisible hand of the price mechanism in which the hidden hand of the market
operating through the pursuit of self-interest allocated resources in society’s best interest. This remains a view
held by free-market economists who believe in the virtues of an economy with minimal state intervention.

Question 2

What is the price mechanism?

Answer 2

The price mechanism describes how decisions taken by consumers and businesses interact to determine the
allocation of scarce resources between competing uses.

Question 3

What are the three functions of the mechanism?

Answer 3

Signalling
Incentive
Rationing

Question 4

Explain the signalling function

Answer 4

Prices perform a signalling function – i.e. they adjust to demonstrate where resources are required. Prices rise
and fall to reflect scarcities and surpluses:
- If prices are rising because of high demand from consumers, this is a signal to suppliers to expand
production to meet the higher demand
- If there is excess supply in a market, the price mechanism will help to eliminate a surplus of a good
by allowing the market price to fall.

Question 5

Explain the incentives function

Answer 5

Through choices consumers send information to producers about their changing nature of needs and wants.
Higher prices act as an incentive to raise output because suppliers stand to make a better profit. When demand
is weaker in a recession, supply contracts as producers cut back on output. One 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.

Question 6

Explain the rationing function

Answer 6

Prices ration scarce resources when demand outstrips supply. When there is a shortage, price is bid up –
leaving only those with willingness and ability to pay to purchase a product.

Question 7

What are secondary markets?

Answer 7

Secondary markets occur when buyers and sellers are prepared to use a second market to re-sell items that
have already been purchased. Perhaps the best example is the secondary market in tickets for concerts and sporting-events.

Question 8

How can government intervention change the incentives of consumers and producers?

Answer 8

For example,
there may be changes in relative prices brought about by subsidies and indirect taxation. The government
might also intervene through imposing maximum and minimum prices.
However, economic agents (e.g. consumers and businesses) may not always respond to incentives in the manner in which textbook
economics suggests. Furthermore, the “law of unintended consequences” encapsulates the idea that
government intervention can often be misguided or have unintended consequences

Question 9

Show how an increase in supply in one market may impact upon other markets

Answer 9

Question 10

Show how a decrease in demand in one market may impact upon other markets

Answer 10