4.1.8.1 how markets and prices allocate resources

Question 1

what does the price mechanism do?

Answer 1

• determines the market price
• resources are allocated through the price mechanism in a free market economy
• the economic problem of scarce resources is solved through this mechanism
  -> the price moves resources to where they’re demanded / where there’s a shortage and removes resources from where there’s a surplus

Question 2

what is the rationing function?

Answer 2

• when there are scarce resources, price increases due to the excess of demand
• the increase in price discourages demand and rations resources

eg) plane tickets might increase as seats are sold, spaces are running out
-> this is a disincentive to some consumers to purchase tickets which rations the tickets

Question 3

what is the incentive function?

Answer 3

• encourages a change in behaviour of consumer or producer

eg) high price would encourage firms to supply more to the markets, because it’s more profitable to do so
vice versa

Question 4

what is the signalling function?

Answer 4

• price acts as a signal to consumers and new firms entering the market
• high price signals firms to enter the market because it’s profitable
• encourages consumers to reduce demand and therefore leave the market
  -> shifting demand and supply curves

Question 5

what is the price mechanism?

Answer 5

the way in which the basic economic problem is resolved in a market economy

Question 6

what is the invisible hand?

Answer 6

made by Adam Smith - father of economics

• he proposed the idea of the invisible hand
  -> if governments didn’t intervene with the market, this would eventually cause an equilibrium within the market

Question 7

what are some advantages of the price mechanism and of extending its use into new areas of activity?

Answer 7

• price mechanism is an impersonal method of allocating resources
• invisible hand can signal what the cost of purchasing a good is to a consumer, also acts as a signal to producers to them tell what revenue they’ll receive
• allows consumers to gain sovereignty in the market
  -> they have ‘spending votes’ in the market
  -> this enables them to choose what’s brought and sold
• the free market allows for an efficient allocation of resources

Question 8

what are some disadvantages of the price mechanism and of extending its use into new areas of activity?

Answer 8

• introducing price mechanism in some fields of human activity could be undeseriable
• there may be inequality in income + wealth with the price mechanism
• doesn’t consider what the distribution of income is
  -> those with more money have more buying power, whilst those without money are left out
• price mechanism and the free market ignore equality
  -> can be argued that inequality exists
  -> the degree of inequality may vary between capitalist societies
• in a free market there’s under-provision of public and merit goods
  -> which requires government interaction