CH13 The price mechanism

Question 1

what does the price mechanism in a market economy do?

Answer 1

it allocates resources between conflicting uses.

Question 2

what are the 3 important functions that price has in allocating resources in a market?

Answer 2

• a rationing function
• a signalling function
• an incentive function

Question 3

explain a bit about the rationing function

Answer 3

-consumer wants are infinite, but we live in a world of scarce resources.
-somehow, those scare resources need to be allocated between competing uses.
-one function of price in a market is to allocate and ration those resources.
-if many consumers demand a good, but its supply is relatively scarce, then prices will be high. Limited supply will be rationed to those buyers who are prepared to pay a high enough price. If demand is relatively low, but supply is very high, then prices will be low. The low price ensures that high numbers of goods will be bought, reflecting the lack of scarcity of the good.

Question 4

explain a bit about the signalling function

Answer 4

-the price of a good is a key piece of information to both buyers and sellers in the market.
-prices come about because of the transactions of buyers and sellers. They reflect market conditions and therefore act as a signal to those in the market. Decisions about buying and selling are based on those signals

Question 5

explain a bit about the incentive function

Answer 5

-price acts as an incentive for buyers and sellers.
-low prices encourage buyers to purchase more goods. For consumers, this is because the amount of satisfaction or utility gained per pound spent increases relative to other goods. Higher prices discourage buying because consumers get fewer goods per pound spent.
-on the supply side, higher prices encourage suppliers to sell more to the market. Low prices discourage production.

Question 6

what is meant by the incentive function?

Answer 6

when changes in price encourage buyers and sellers to change the quantity they buy and sell. A rise in price encourages buyers to purchase less and sellers to produce more; and vice versa

Question 7

what is meant by the rationing function?

Answer 7

when changes in price lead to more or less being produced, so increasing or limiting the quantity demanded by buyers

Question 8

what is meant by the signalling function?

Answer 8

when changes in price give information to buyers and sellers which influence their decisions to buy and sell.