1.2.7: Price Mechanism

Question 1

What does the price mechanism do in a free market economy?

Answer 1

• It allocates resources.
• Price is determined by the interactions of demand and supply.
• Adam Smith described the invisible hand of the market, how the price mechanism is able to set prices.

Question 2

What are the three main characteristics of the price mechanism?

Answer 2

• The rationing function
• The signalling function
• The incentive function

Question 3

How does the price mechanism act as a rationing function?

Answer 3

• It is a way of rationing goods because when prices increases, some people will no longer be able to afford to buy the product, others may no longer want the goods.
• Limited resources can be rationed and allocated to the people who are able to afford them and those who value them most highly

Question 4

How does the price mechanism act as a signalling function?

Answer 4

• Acts as a signal where resources should be used.
• When prices rise, producers move resources into the manufacture of that product.
• Changes in prices signal to suppliers and consumers that market conditions have changed.

Question 5

How does the price mechanism act as an incentive function?

Answer 5

• It’s an incentive for people to work hard.
• Buyers know that the more money they have, they are able to buy more products.
• Suppliers know that if they produce more of the goods, they will make more supernormal profit.
• The price mechanism encourages people to behave a certain way.

Question 6

Price Mechanism in local Markets

Answer 6

• COVID disrupted supply chains
• eg: In British supermarkets, less imports from other countries meant there were fewer goods on the shelves.
• Demand was high, supply was low which led to the price of food rising to ration off the excess demand.
• example of rationing function

Question 7

Price Mechanism in national Markets

Answer 7

• The housing prices across the UK
• As the population of London is relatively high compared to the rest of the UK, house prices will rise, to ration off excess demand and only provide houses to those who value them the most.
• The high house prices in LDN also offer an incentive for firms to allocate resources to the production of more houses, as there is profit to be made
• example of rationing and incentive function

Question 8

Price Mechanism in Global Markets

Answer 8

• OPEC (Organisation for Petroleum Exporting Countries)
• In 1973, they restricted the supply of oil on an insurmountable scale, due to geopolitical factors between USA and the Middle East.
• Caused the price of oil to be VERY high
• AN example of rationing function as the disequilibrium of supply and demand meant the high prices deterred consumers who didn’t’ value oil highly.