2.5 The role of price mechanism and market efficiency

Question 1

how does society make a choice about resource allocation?

Answer 1

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

Question 2

what does an increase in price signal to producers + how is it an incentive

Answer 2

• 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

Question 3

what does an increase in price signal to consumers + how is it an incentive

Answer 3

• a higher price signals to consumers that a good is now more expensive
• it is therefore an incentive to buy less, decreasing quantity demanded

Question 4

what does a decrease in price signal to producers + how is it an incentive

Answer 4

• a lower price signals to producers that there has been a surplus
• it is therefore an incentive to decrease the quantity supplied

Question 5

what does a decrease in price signal to producers + how is it an incentive

Answer 5

• 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

Question 6

how is it a reallocation of resources

Answer 6

if there is an increase in demand, the price and quantity supplied will increase and therefore more resources are allocated to this good

Question 7

what is price rationing

Answer 7

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.

Question 8

what is non-price rationing

Answer 8

rationing that is not based on price, e.g. waiting line or queue, first come first serve

Question 9

Define ‘allocative efficiency’

Answer 9

social optimal state that is achieved when the economy allocates its resources so that society gets the most benefits from consumption
(MB = MC)

Question 10

Define ‘marginal benefit’

Answer 10

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)

Question 11

what curve shows marginal benefit

Answer 11

the demand curve

Question 12

how does marginal benefit relate to demand curve

Answer 12

quantity demanded will only increase if its price falls, as marginal benefit decreases with an increase in consumption

Question 13

Define ‘marginal cost’

Answer 13

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

Question 14

what curve shows marginal cost

Answer 14

the supply curve

Question 15

how does marginal cost relate to supply curve

Answer 15

quantity supplied will only increase if price increases, as marginal cost increases when production increases

Question 16

What is allocative efficiency

Answer 16

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

Question 17

What is allocative inefficiency

Answer 17

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

Question 18

Define ‘consumer surplus’

Answer 18

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

Question 19

Define ‘producer surplus’

Answer 19

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

Question 20

what is social surplus

Answer 20

at the point of competitive market equilibrium,
social surplus, defined as the sum of consumer + producer surplus, is maximised

*allocative efficiency

Question 21

what is social welfare

Answer 21

amount of consumer and producer surpus, when social surplus is maximum, social welfare is maximum

Question 22

why is market equilibrium important

Answer 22

market equilibrium = allocative efficiency. Therefore society is making the best use of its scarce resources

quantity demanded = quantity supplied
marginal benefits = marginal costs

Question 23

what does it mean when we are at allocative efficiency

Answer 23

• social welfare is maximised when MB = MC and when social surplus is maximum
• resources are being allocated efficiently - society’s best interests

Question 24

When do government have to intervene

Answer 24

market failure = when the market is unable to achieve allocative efficiency

Question 25

what happens when there is allocative inefficiency

Answer 25

social surplus is not maximised which results in welfare loss (deadweight loss)

Question 26

difference between market disequilibrium and allocative inefficiency

Answer 26

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

Question 27

what are the consequences of allocative inefficiency

Answer 27

1. 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
2. inequity:
   - unequal distribution of resources, where some groups benefit while others lose out
3. environmental sustainability
   - if there is an overallocation of resources that are harmful to the environment this could have negative impacts on the environment