8.1 How Markets And Prices Allocate Resources

Question 1

What is the price mechanism?

Answer 1

• The price mechanism determines the market price.
• Adam Smith called this ‘the invisible hand of the market’.
• Resources are allocated through the price mechanism in a free market economy.
• The economic problem of scarce resources and the basic economic problem is resolved in a market economy through this mehanism
• The price moves resources to where they are demanded or where there is a shortage, and removes resources from where there is a surplus

Question 2

What are the three functions of the price mechanism?

Answer 2

• rationing
• incentive
• signalling

Question 3

What is the rationing function?

Answer 3

• When there are scarce resources, price increases due to the excess of
  demand
• increase in price discourages demand and rations resources.
• For example, plane tickets might rise as seats are sold, because spaces are running out.
• This is a disincentive to some consumers to purchase the tickets, which rations the tickets.

Question 4

What is the incentive function?

Answer 4

• encourages a change in behaviour of a consumer or producer.
• For example, a high price would encourage firms to supply more to the market,
  because it is more profitable to do so.

Question 5

What is the signalling function?

Answer 5

• price acts as a signal to consumers and new firms entering the market.
• price changes show where resources are needed in the market.
• A high price signals firms to enter the market because it is profitable.
• However, this encourages consumers to reduce demand and therefore leave the market, this shifts the demand and supply curves.

Question 6

What are some advantages of the price mechanism and it’s use into new areas of activity?

Answer 6

• price mechanism is an impersonal method of allocating resources.
• Introducing the price mechanism into some fields of human activity could be
  undesirable
• the invisible hand can signal what the cost of purchasing a good is to a consumer.
• also acts as a signal to producers to tell them what revenue they will receive.
• allows the consumer to gain sovereignty in the market.
• they have ‘spending votes’ in the market, which enables them to choose what is bought and sold.
• Generally, the free market allows for an efficient allocation of resources.

Question 7

What are some disadvantages of the price mechanism and it’s use into new areas of activity?

Answer 7

• may be inequality in income and wealth with the price mechanism.
• does not consider what the distribution of income is.
• Those with money have buying power, whilst those without money are left out.
• the price mechanism and the free market ignore equality.

Question 8

Give an evaluation of the price mechanism

Answer 8

• To evaluate, it can be argued that inequality exists, but the degree of inequality may vary between capitalist societies.
• In a free market, there is the under-provision of public and merit goods, which
  requires government intervention.