Chapter 1.2 - Free Market Economies & the Price Mechanism

Question 0

State 5 main characteristics of a free market economy.

Answer 0

1. Private ownership of resources
2. Market forces determine prices
3. Producers aim to maximise profits
4. Consumers aim to maximise satisfaction
5. Resources are allocated by the price mechanism

Question 1

What is a free market economy?

Answer 1

A free market economy refers to an economy in which the market forces of demand and supply determine how resources are allocated.

Question 2

State 7 advantages of free market economies.

Answer 2

1. Consumer sovereignty - spending decisions by consumers determine what is produced.
2. Flexibility - the free market system can respond quickly to consumer wants.
3. No officials are needed to allocate resources.
4. Profit motive - provides an incentive for firms to take risks.
5. Competition and the profit motive help to promote an efficient allocation of resources.
6. Increased choice for consumers compared with a command economy.
7. Economic and political freedom for consumers and producers - to own resources.

Question 3

State and explain 5 disadvantages of free market economies.

Answer 3

1. Inequality - those who own resources are likely to become richer than those who don’t.
2. Trade cycles - free market economies may suffer from instability in the form of booms and slumps.
3. Imperfect information - consumers may be unable to make rational choices if they have inadequate information or if there is asymmetric information.
4. Monopolies - there is a danger that a firm may become the sole supplier of a product and then exploit consumers by charging higher prices than the free market equilibrium.
5. Externalities - these are costs and benefits which aren’t considered when goods are produced and consumed.

Question 4

What is a mixed economy?

Answer 4

A mixed economy is a combination of a free market economy and a command economy.

Question 5

Define ‘demand’.

Answer 5

Demand refers to the amount consumers are willing and able to buy at each price over a given time period.

Question 6

Name 6 factors which will shift the demand curve.

Answer 6

1. Real incomes
2. Size or age distribution of population
3. Changing tastes and fashions
4. Prices of substitutes or compliments
5. Amount of advertising or promotion
6. Interest rates

Question 7

Define ‘supply’.

Answer 7

Supply refers to the amount producers are willing and able to supply at each price over a given time period.

Question 8

Name 6 factors which will shift the supply curve.

Answer 8

1. Costs of production
2. Productivity of the workforce
3. Indirect taxes
4. Subsidies
5. Technology
6. Discovery of new reserves of a raw material

Question 9

What are the functions of the price mechanism in free market economies?

Answer 9

1. As a rationing device - market forces will ensure that the amount demanded is totally equal to the amount supplied.
2. To determine changes in wants - a change in demand will be reflected in a change in price.
3. As a signalling device - indicates to producers to increase/decrease the amount supplied.
4. As an incentive - the idea of making a profit encourages firms to produce goods and services.

Question 10

When does excess demand occur?

Answer 10

Excess demand occurs if the price is below the equilibrium price, where the quantity demanded exceeds the quantity supplier at the current price.

Question 11

When does excess supply occur?

Answer 11

Excess supply occurs if the price is above the equilibrium price, where the quantity supplied exceeds the quantity demanded at the current price.

Question 12

What 2 things causes a change in the equilibrium price?

Answer 12

A change in the conditions of demand or supply (e.g. a shift).