3.8.1 - How Markets and Prices Allocate Resources

Question 1

What are the precise functions that prices perform?

Answer 1

Signalling
Incentive
Rationing
Allocative

Question 2

What is the signalling function of prices?

Answer 2

Prices provide information to buyers and sellers.

They adjust to reflect scarcities and surpluses.

Question 3

Give an example of the signalling function of prices?

Answer 3

The prices of graphics cards rising providing information to Nvidia to increase production.

Question 4

What is the incentive function of prices?

Answer 4

Prices create a reason for people to alter their economic behaviour.

Question 5

What is an example of the incentive function?

Answer 5

A higher price provides incentive for people to alter their economic behaviour.

Question 6

What is the rationing function of prices?

Answer 6

Increasing the price to reduce demand for a product.

Question 7

Draw a graph demonstrating the incentive and rationing functions of prices.

Answer 7

Question 8

What is an example of rationing and incentive functions?

Answer 8

Due to rising wages in a labour market, the demand for labour of a firm is rationed.

Question 9

What is the allocative function of prices?

Answer 9

Changing relative prices allocate scarce resources away from markets with excess supply to those with excess demand.

Question 10

What is the relationship between the rationing function of prices and allocative function of prices?

Answer 10

The allocative function of prices moves resources between markets, the rationing function of prices moves resources within markets to those who wants them the most.

Question 11

How do prices coordinate the decision making of buyers and sellers?

Answer 11

Incentive function of prices
Rationing and allocative function of prices

Question 12

What are the advantages of the price mechanism? (in competitive markets)

Answer 12

• Promotes consumer sovereignty
• Productively efficient allocation of resources
• Allocatively efficient allocation of resources

Question 13

How is consumer sovereignty a benefit of the price mechanism?

Answer 13

Goods and services are produced only if consumers ‘vote’ for them by spending on them.

Firms / industries that produce goods that consumers do not wish to buy, do not survive in these markets.

Question 14

How is a productively efficient allocation of resources a benefit of the price mechanism?

Answer 14

As the market is highly competitive, costs are reduced to prevent firms from going out of business.

These cost savings can then be transferred onto consumers.

Question 15

How is allocative efficiency a benefit of the price mechanism?

Answer 15

Producers supply only what society demands, so there is no over-consumption or under-consumption.

(It is impossible to measure exactly what society demands though)

Question 16

What are the disadvantages of the price mechanism? (in imperfectly competitive markets)

Answer 16

• Asymmetric market information and market power, promoting producer sovereignty
• Manipulation of consumer wants through marketing such as persuasive marketing
• Price mechanism is ‘value-neutral’

Question 17

Why is the asymmetric market information a disadvantage of the price mechanism?

Answer 17

Firms are able to exploit their producer sovereignty so goods and services available for consumers are determined by firms rather than consumers.

Question 18

Why is the manipulation of consumer wants a negative of the price mechanism?

Answer 18

Large imperfectly competitive firms will be able to manipulate consumer wants through persuasive advertising making the producer sovereign rather than the consumer.

Question 19

Why is the price mechanism being ‘value neutral’ a disadvantage of the price mechanism?

Answer 19

There is no regard for equality and the allocation of buying power between different incmoe groups.

This leads to numerous market failures.

Question 20

What is the case for extending the operation of the price mechanism?

Answer 20

Free marketeers believe that the price mechanism works well and gov. intervention works badly.

The risk of gov. failure produces an outcome worse than market failure, so the price mechanism should be extended into areas of the economy that were previously dominated by the state provision of goods.

Question 21

What is the case for extending the operation of the price mechanism?

Answer 21

Free marketeers believe that the price mechanism works well and gov. intervention works badly.

The risk of gov. failure produces an outcome worse than market failure, so the price mechanism should be extended into areas of the economy that were previously dominated by the state provision of goods.

Question 22

What is the case against extending the operation of the price mechanism?

Answer 22

Interventionists believe that markets often perform badly and gov. intervention can improve this operation.