4.1.8.1 - How Prices And Markets Allocate Resources

Question 1

Define signalling function

Answer 1

◦ Prices carry information Used by consumers and producers to create market Plans.

Question 2

Example of signalling function

Answer 2

→ If prices are rising because of high demand from customers, this is a signal to suppliers to expand production and increase supply to meet the higher demand

Question 3

Describe rationing function

Answer 3

• Rising prices of a good show that it is scarce, some consumers bid against each other as they all want the scarce good, so the price is increased as consumers will bid more in order to obtain the good. Other consumers will be bid out of the market as they are not willing and able to spend as much.
→ therefore prices can ration goods for consumers

Question 4

Describe allocative function

Answer 4

Rising prices may lead to scarce resources being allocated to the production of goods that the customers most desire. Producers will seek the goods or services with the highest profits attached.
→ prices can therefore cause firms to allocate resources to their production

Question 5

Describe the incentive function

Answer 5

• high prices give an incentive to firms to produce more of the product as higher profit will be received.

• lower prices may incentivise consumers to purchase more
as they want to maximise their utility by seeking
goods at the lowest possible price.

Question 6

What is price mechanism

Answer 6

Also know an as the invisible hand of the market:

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 are demanded or where there is a shortage, and removes resources from where there is a surplus.

So, price mechanism is the way in which the basic economic problem is resolved in a market economy

Question 7

Cons of price mechanism

Answer 7

• An impersonal way of allocating resources:
  there may be inequality in income and wealth with the price mechanism. It does not consider what the distribution of income is. Those with money have buying power, whilst those without money are left out.
• it is an inappropriate method of allocating goods and resources in fields of human activity. Medical supplies such as organ donations and blood transfusions should be given to those who need them most, not those who have the most money. It changes the nurture of the incentivise involved

Question 8

Pros of price mechanism

Answer 8

• The invisible hand can signal what the cost of purchasing a good is to a consumer, so acts as a signal to producers to tell them what revenue they will receive.
• allows the consumer to gain sovereignty (power) in the market as they have ‘spending votes’ in the market, which enables them to choose what is bought and sold.
• So generally, the free market allows for an efficient allocation of resources.