1.3.4 Price Mechanism

Question 1

Price mechanism

Answer 1

The means by which decisions of consumers and businesses interact to determine the allocation of resources.

Question 2

Signalling (as a PMF)

Answer 2

Prices give signals to producers and consumers

Question 3

Rationing (as a PMF)

Answer 3

Only those willing and able to pay the price get the products or resources

Question 4

Incentives (as a PMF)

Answer 4

Profitability motivated firms; value for money motivates consumers

Question 5

Economic models

Answer 5

Use simplified assumptions to describe economic relationships.

Allow us to isolate individual changes and analyse their consequences, avoiding complications that occur when several things are changing at once.

Their success depends on how realistic the assumptions are.

Question 6

Allocation of resources

Answer 6

Reflects the way in which economic agents take decisions about what to buy, what to produce and how best to use the available land, labour and capital

Question 7

Price mechanism

Answer 7

An economic model that helps us explain the allocation of resources towards production of what consumers will buy

Question 8

Homogeneous

Answer 8

Uniform products, identical whatever their origin (eg all bananas look similar)

Question 9

Differentiated

Answer 9

Distinctive products, different design features or branding

Question 10

Mass markets

Answer 10

Products are supplied in significant quantities to all or most types of customers

Question 11

Oligopoly

Answer 11

Market structure with a few large firms dominating the market; often smaller firms competing as well → present in many mass markets

Question 12

Market power

Answer 12

Firms have it when they can differentiate the product and control the amount produced and the price charged

Question 13

Niche market

Answer 13

Small segment of a market with distinctive, specialised requirements. They may be associated with subcultures - groups of people with common interests

Question 14

what are the three price mechanism functions

Answer 14

1. profit signalling
2. rationing
3. incentive

Question 15

profit signalling

Answer 15

Prices and demand act as market signals that guide businesses on how to use resources available → demonstrate where resources are required

If prices rise, its because of high demand from consumers → signal to suppliers to expand production to meet higher demand

Excess supply → PM helps eliminate a surplus of a good by allowing the market price to fall

Question 16

rationing

Answer 16

ensuring only the ‘highest bidder’ (both willing and able to pay) gets to purchase the good
- Prices ration scarce resources when demand outstrips supply
- When there is a shortage prices bid up and only those with the willingness and ability to buy are left (effective demand)

Question 17

incentive

Answer 17

motivations to buy or sell goods and services; includes the opportunity cost, probability of profit or changing demands

• Market prices give a variety of prompts for action/inaction → consumers send info to producers about the changing nature of needs and wants

Question 18

free market vs planned economy

Answer 18

Free market → decision making is decentralised, no single body deciding what to produce and what quantities

In contrast, planned economic systems: significant intervention in market prices and state ownership of key industries

Question 19

imposition of tax

Answer 19

(sugar, tobacco, alcohol)

Adding tax makes the good more expensive to supply, so there is less profit and less is made and supplied

Tax shifts the supply curve upwards (to the left) by the amount of tax

Quantity consumed decreases as the price has risen → demand has contracted

the tax revenue will be the amount of the tax per unit x quantity sold
(p1 - p2) x q1

P1-p2 = amount of tax per unit

P → p1 is the consumer burden of tax (having to pay more)

P → p2 is the producer burden of tax (raw materials are taxed so more expensive to make, consumers buy less as it is now expensive so less profit)

Question 20

imposition of a subsidy

Answer 20

When the gov subsidies a good the supply curve shifts downwards by the amount of the subsidy.

There is a new equilibrium, with lower price and higher quantity supplied, so demand extends and more is consumed.

Total cost of the subsidy → (p2-p1) x q1

P2 → p = producer gain (less expensive to make, higher demand, more profit)
P → p1 = consumer gain (less expensive)

Question 21

what are the 2 advantages of PM

Answer 21

1. Works automatically, following decisions taken by a number of economic agents
2. Can direct resources to the best possible use

Question 22

PM and consumer welfare

Answer 22

Each individual thinks about their welfare when making decisions.

• These are fed into the PM by making spending choices that fuel the process of resource allocation.
• Consumers have control and logically should choose the resource which gives them the greatest welfare or satisfaction.

Question 23

economic models

Answer 23

Economic models: simplified structures that help us analyse the way the economy works and draw conclusions about how specific events change outcomes.

For the PM, the model explains how the allocation of resources changes in response to changing consumer preferences

Depend on reasonable assumptions that are not always realistic.
- Eg competition promotes cost efficiency and low prices → in some but not all markets
- Eg consumers are rational, making logical choices

Question 24

price mech and income distribution

Answer 24

Price mechanism makes little difference to income distribution:

• Wealthiest 1% own 47% of income in USA → many spending decisions determining resource use are dominated by the very rich
• Resources used for expensive sports cars while people are homeless/hungry
• Poverty increased in the UK from 2010-15, but incomes of top earners grew fast → PM does not show this

Question 25

the market

Answer 25

• one dominant mass market with several smaller niche markets
• eg in confectionary –> dominant segment is a plain chocolate bar (cadbury’s, nestle, mars), with specialist niche segments like luxury, organic or fairtrade choc

Question 26

mass markets

Answer 26

Some products are used by most, so are bought and sold in very large quantities.

• These products are standardised or homogeneous, with little or no difference between what is offered by different suppliers (eg milk, sliced bread, sugar, copper)
• Hard for producers to differentiate their product to make them stand out from competition
• Large scale production allows firms to keep production costs low, competition in mass markets tends to be based on price

Question 27

standard characteristics of mass markets

Answer 27

• customers form the majority
• customers needs and wants are more general
• associated with higher production output and capacity
• success usually associated with low cost operation, heavy promotion, widespread distribution or market-leading brands
• more competitors, more substitutes, can lose demand if charging a higher price so should lower price –> price elastic

Question 28

oligopolies

Answer 28

Growth mergers and privatisation an all create large firms that build strong positions in some mass markets (eg coca cola and british gas, google and microsoft)

• Where there are several large firms and each have a market share, there is an oligopoly → can change the nature of competition
• Oligopolies watch eachothers actions and closely respond → if one brings out a new product, others might do that too or increase their advertising to maintain their market share
• Competition can be fierce and the largest firms may have considerable market power

Question 29

niche markets

Answer 29

They are specialised sections of a larger market, separated by particular needs or preferences (eg organic foods, reptilian pets → small groups of the populations whose preferences are niche)

Question 30

how can small firms succeed in niche markets

Answer 30

Small firms in mass markets may be dwarfed by the large scale and market power of the biggest producers, so they might make more profit in niche markets.

• They can start on a small scale, with a modest initial investment
• If they can accurately meet the needs of their niche customers, they can build a reputation and customer loyalty
• Successful niche suppliers face less direct competition and can sometimes charge premium prices → can acquire market power within their niche
• Highly specialised niches offer only tiny sales in one locality, but online trading allows businesses to cater for far away customers

Question 31

advantages of a niche market

Answer 31

1. less competition –> fewer competitors, fewer substitutes, can charge a higher price as price INELASTIC
2. clear focus as particular customers are targeted
3. builds up specialist skills and knowledge: market expertise
4. can often charge a higher price –> customer are willing to pay for expertise
5. profit margins are higher
6. customers tend to be more loyal

Question 32

disadv of a niche market

Answer 32

1. higher unit costs as operating at lower production volumes
2. risk of overdependence ona single market/product
3. likely to attract competition if successful
4. vulnerable to market changes

Question 33

creative destruction - joseph schumpeter, potential growth

Answer 33

1. New tech developed
2. New products mean new employment opportunities
3. Growing demand creates more jobs
4. New and better substitutes are developed and consumers switch to these
5. Jobs are lost in the now declining industry

Question 34

maximum prices

why are they important

Answer 34

A legally imposed maximum price (price ceiling) in a market that suppliers cannot exceed
- Prevents prices from rising above a certain level/threshhold
- Improves affordability for consumers, especially those on lower incomes
Eg housing rents, energy prices, salary caps in sport

Question 35

how do maximum prices work

Answer 35

A price above p makes no difference

At Pmax, there is not an equilibrium as demand does not equal supply, so there is excess demand

Without max prices set by the government, the market would ration the good by the interaction of D and S, and demand would contract as price moves to Pe

With a regulatory system and a max price, the government councils has a way to ration the good by
Rationing
Waiting lists
Black market/informal

Question 36

minimum prices

Answer 36

A legally imposed price floor
- most associated with minimum hourly wage rates in the labour market or guaranteed price support schemes for farmers and other producers
- Might be a legal minimum retail price such as the minimum alcohol price introduced into Scotland

Question 37

how do minmum prices work (minimum wage)

Answer 37

At any point above the market equilibrium, there would be excess supply as qs>qd, or unemployment

At a higher wage more people are prepared to work so supply of workers extends but firms cannot afford to employ as many workers so demand for labour contracts (lots of it, but not as much needed)

1998: Tony Blair and Gordon Brown introduced national min wage but at a low rate and gradually increased → avoided mass unemployment (jobs would run out really quickly)