1.3.4 Price Mechanism Flashcards
Price mechanism
The means by which decisions of consumers and businesses interact to determine the allocation of resources.
Signalling (as a PMF)
Prices give signals to producers and consumers
Rationing (as a PMF)
Only those willing and able to pay the price get the products or resources
Incentives (as a PMF)
Profitability motivated firms; value for money motivates consumers
Economic models
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.
Allocation of resources
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
Price mechanism
An economic model that helps us explain the allocation of resources towards production of what consumers will buy
Homogeneous
Uniform products, identical whatever their origin (eg all bananas look similar)
Differentiated
Distinctive products, different design features or branding
Mass markets
Products are supplied in significant quantities to all or most types of customers
Oligopoly
Market structure with a few large firms dominating the market; often smaller firms competing as well → present in many mass markets
Market power
Firms have it when they can differentiate the product and control the amount produced and the price charged
Niche market
Small segment of a market with distinctive, specialised requirements. They may be associated with subcultures - groups of people with common interests
what are the three price mechanism functions
- profit signalling
- rationing
- incentive
profit signalling
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
rationing
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)
incentive
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
free market vs planned economy
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
imposition of tax
(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)
imposition of a subsidy
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)
what are the 2 advantages of PM
- Works automatically, following decisions taken by a number of economic agents
- Can direct resources to the best possible use
PM and consumer welfare
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.
economic models
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
price mech and income distribution
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
the market
- 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
mass markets
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
standard characteristics of mass markets
- 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
oligopolies
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
niche markets
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)
how can small firms succeed in niche markets
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
advantages of a niche market
- less competition –> fewer competitors, fewer substitutes, can charge a higher price as price INELASTIC
- clear focus as particular customers are targeted
- builds up specialist skills and knowledge: market expertise
- can often charge a higher price –> customer are willing to pay for expertise
- profit margins are higher
- customers tend to be more loyal
disadv of a niche market
- higher unit costs as operating at lower production volumes
- risk of overdependence ona single market/product
- likely to attract competition if successful
- vulnerable to market changes
creative destruction - joseph schumpeter, potential growth
- New tech developed
- New products mean new employment opportunities
- Growing demand creates more jobs
- New and better substitutes are developed and consumers switch to these
- Jobs are lost in the now declining industry
maximum prices
why are they important
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
how do maximum prices work
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
minimum prices
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
how do minmum prices work (minimum wage)
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)
