Functions of the price mechanism

Question 1

Adam smiths invisible hand

Answer 1

• Adam smiths “invisible hand” of the price mechanism is said to allocate resources in society’s best interest
• Free market economists believe in the virtues of an economy with minimal government intervention

Question 2

The price mechanism

Answer 2

Th price mechanism describes the means by which decisions taken by consumers and businesses interact to determine the allocation of scarce resources between competing uses

Question 3

Price mechanisms three main functions in a market

Answer 3

• Signalling function
• Transmissions of preferences/ incentivising
• Rationing functions

Question 4

Signalling function

Answer 4

• Prices adjust to demonstrate where resources are required, and where they are not
• Prices rise and fall to reflect scarcities and surpluses
• If prices are rising because of high demand from consumers, this is a signal to suppliers to expand production to meet the higher demand
• If there is excess supply in the market the price mechanism will help to eliminate a surplus of a good by allowing the market price to fall

Question 5

Transmission of preferences/ incentivising

Answer 5

• Through their choices consumer send information to producers about the changing nature of needs and wants
• Higher prices act as an incentive to rise output because the supplier stands to make better profit
• When demand is weaker in a recession then supply contracts as producers cut back on output
• One of the features of a market economy system is that decision making is decentralised e.g. there is no single body responsible for deciding what is to be produced and in what quantities

Question 6

Ratioing function

Answer 6

• Prices serve to ration scarce resource when demand in a market outstrips supply
• Where there is a shortage the price is bid up - leaving only those with the willingness and ability to pay to purchase the product
• Examples
  > Concert tickets
  > Gold

Question 7

Market failure

Answer 7

• This occurs when the signalling and incentive functions of the price mechanism fail to operate optimally, leading to a loss of economic and social welfare
• For example, the market may fail to take into account the externa costs and benefits arising from production and consumption
• Consumer preferences for goods and services may be based on the private costs and benefits of a particular decision to buy and consumer a product

Question 8

Secondary market

Answer 8

• Secondary market occur when buyers and sellers are prepared to use a second market to re-sell items that have already been purchased
• Perhaps the best example is the secondary market in tickets for concerts and sporting events

Question 9

Interrelationships between markets

Answer 9

• Substitutes
• Complements
• Joint supply
• Composite demand
• Derived demand

Question 10

Substitutes

Answer 10

• Good which can be used/ consumed as alternative to each other
• Pepsi and Coke

Question 11

Complements

Answer 11

• These are goods which are joint demand, e.g. they tend to be consumed together
• Milk and cereal

Question 12

Joint supply

Answer 12

• When two or more are produced together
• Beef and leather

Question 13

Composite demand

Answer 13

• When the total demand for a product is made of different and distinct uses
• The travel market is split between business and leisure

Question 14

Derived demand

Answer 14

• When the demand for a product is derived from the demand for another
• The demand for chips is derived from the demand for computers