1.5 How markets work: The price mechanism in action + Economic systems Flashcards
What is the price mechanism?
The millions of decisions made by consumers and producers which then determines how scarce resources can be allocated through a price.
What are the 3 functions of the price mechanism?
Signalling function - prices adjust to demonstrate where resources are required, reacting to scarcities and surpluses - when there is high demand it signals suppliers to expand production and if there is excess supply the price mechanism will eliminate this by allowing the price to fall
Incentive function - changing needs and wants incentivises producers to start producing or new entrants to join that market
Rationing function - prices ration scarce resources when demand is greater than supply. When there is a shortage, prices rise up leaving only those able to pay to purchase the product.
What is an economic system?
A network of individuals and organisations who resolve the economic problem of how to allocate resources, made up of private and public sectors.
Private - owned by private firms or individuals
Public - owned by the state.
What is a free market economy?
Markets allocate resources through the price mechanism. An increase in demand raises prices and encourage businesses to put more resources into production.
Firms are incentivised to use their resources to maximise profit.
Changes in equilibrium signal the market to produce more or less.
Consumption by individuals depends on their income which depends on the value of their work. There is limited role for the government - only using the legal system to protect value of money or property rights.
What are the advantages of a free market?
In theory an efficient allocation of scarce resources as inputs go where profit is highest and most desired
Competitive prices for consumers as suppliers look to increase and protect market share
Competition drives innovation and invention - dynamic efficiency
Profit motive stimulates investment and EofS
Competition reduces monopoly power
Faster economic growth
What are the disadvantages of a free market?
Inequalities for those unable to work
Demerit goods may be over produced, merit goods under produced as not profitable
Profit motive causes firms to cut costs and exploit labour
Monopoly power without intervention
Public goods not provided
What is a planned economy?
The state allocates all resources, deciding what and how much is produced according to the states views. Market prices pay very little price and scarce goods generally rationed.
What is a mixed economy?
Some resources are owned by the public sector and some by the private sector. The public sector typically supplies public and merit goods and corrects market failures. Most economies are mixed
What are the advantages of a planned economy?
Low level of inequality and unemployment
Resources allocated to common good rather than profit motive - healthcare and education provided
More straightforward to get projects built
Money not diverted to shareholders so can improve product and pay better wages
What are the disadvantages of a planned economy?
Relies on the government to decide what is produced - lacks price mechanism and planners are unlikely to be as accurate as market to determine prices
Bureaucratic costs as central planning of resources - leads to inefficiencies
Loss of incentive for workers and businesses which damage productivity and lead to losses
State suffers from information failures and corruption
Limits innovation - becomes uncompetitive
What did Adam Smith believe?
Wrote 1776 Wealth of Nations
Resources are automatically allocated through the idea of an invisible hand, and the role of self-interest - in free market economies. This was the price mechanism
What did Karl Marx believe
He published Das Kapital in 1867 and was anti capitalism. He saw profit as theft from workers and goods can be sold for more than what workers are paid to make them, so they are exploited
What did Hayek believe?
Hayek is a member of the Austrian school of economics. He disagreeds with Keynes support of government intervention and Adams smiths support of government intervention in money and financial markets
Hayek saw less of a role for governments in an economy than even Smith - the government should only maintain law and order
What did Keynes believe?
He believed in government intervention during the great depression. He was influential in setting up the IMF and World Bank post WWII.
