2.5 The role of price mechanism and market efficiency Flashcards
how does society make a choice about resource allocation?
through signalling and incentive functions of prices.
- as signals, prices communicate information to decision-makers
- as incentives, prices motivate decision-makers to respond to the information
what does an increase in price signal to producers + how is it an incentive
- a higher price signals to producers that there has been a shortage
- it is therefore an incentive to increase the quantity supplied in order to increase profit
what does an increase in price signal to consumers + how is it an incentive
- a higher price signals to consumers that a good is now more expensive
- it is therefore an incentive to buy less, decreasing quantity demanded
what does a decrease in price signal to producers + how is it an incentive
- a lower price signals to producers that there has been a surplus
- it is therefore an incentive to decrease the quantity supplied
what does a decrease in price signal to producers + how is it an incentive
- a lower price signals to consumers that it is now affordable and cheaper
- it is therefore an incentive to buy more, increasing the quantity demanded
how is it a reallocation of resources
if there is an increase in demand, the price and quantity supplied will increase and therefore more resources are allocated to this good
what is price rationing
price alone is the factor:
- whether or not a consumer will get a good is determined by the price of the good. Those willing and able will get it, those not willing and able will not get it.
what is non-price rationing
rationing that is not based on price, e.g. waiting line or queue, first come first serve
Define ‘allocative efficiency’
social optimal state that is achieved when the economy allocates its resources so that society gets the most benefits from consumption
(MB = MC)
Define ‘marginal benefit’
marginal benefit = the extra benefit you will receive from each additional unit
- as price increases, quantity demanded will decrease as there is a lower marginal benefit from receiving an extra unit of the good (will only buy good at a lower price)
what curve shows marginal benefit
the demand curve
how does marginal benefit relate to demand curve
quantity demanded will only increase if its price falls, as marginal benefit decreases with an increase in consumption
Define ‘marginal cost’
marginal cost = the extra cost of producing each additional unit
- as price increases, quantity supplied will increase as they are able to cover the extra costs
what curve shows marginal cost
the supply curve
how does marginal cost relate to supply curve
quantity supplied will only increase if price increases, as marginal cost increases when production increases
What is allocative efficiency
MB = MC
- the extra benefit to society of getting one more unit of the good is equal to the extra cost to society for producing one more unit of the good
- when society has allocated the right amount of resources to production and is producing the quantity that is most wanted by society
- social welfare is maximised
What is allocative inefficiency
MB > MC
- society would be placing a greater value on the last unit go the good than it’s cost and should therefore produce more
- society would benefit if more of the good was supplied to reach a socially optimal state, where welfare is maximised
MC > MC
- costing society more to produce an additional unit of the good than the value of the good and should therefore produce less
Define ‘consumer surplus’
difference between the price a consumer is willing to pay and the actual price they pay. It represents the benefit received from purchasing the good at a lower price than what they were willing to pay
Define ‘producer surplus’
difference between the price producers are willing to sell for and the actual price received. It represents the benefit received from purchasing the good at a higher price than what they were willing to accept
what is social surplus
at the point of competitive market equilibrium,
social surplus, defined as the sum of consumer + producer surplus, is maximised
*allocative efficiency
what is social welfare
amount of consumer and producer surpus, when social surplus is maximum, social welfare is maximum
why is market equilibrium important
market equilibrium = allocative efficiency. Therefore society is making the best use of its scarce resources
quantity demanded = quantity supplied
marginal benefits = marginal costs
what does it mean when we are at allocative efficiency
- social welfare is maximised when MB = MC and when social surplus is maximum
- resources are being allocated efficiently - society’s best interests
When do government have to intervene
market failure = when the market is unable to achieve allocative efficiency
what happens when there is allocative inefficiency
social surplus is not maximised which results in welfare loss (deadweight loss)
difference between market disequilibrium and allocative inefficiency
market disequilibrium = is when the quantity supplied and quantity demanded is not equal which leads to surpluses or shortages of goods and services
allocative inefficiency = when resources are not allocated in an efficient way and marginal benefit does not equal marginal cost, which leads to welfare loss as social surplus is not maximised
what are the consequences of allocative inefficiency
- welfare loss:
- not producing goods and services that society values most, and not producing at the lowest possible cost, therefore total social surplus is not maximised, leading to welfare loss - inequity:
- unequal distribution of resources, where some groups benefit while others lose out - environmental sustainability
- if there is an overallocation of resources that are harmful to the environment this could have negative impacts on the environment
