How markets and prices allocate resources

Question 1

what does the price mechanism determine

Answer 1

prices

Question 2

state another term for the price mechanism

Answer 2

the invisible hand

Question 3

state what the price mechanism/ the invisible hand is and what it does

Answer 3

the interaction of supply and demand to determine prices
- adjunct prices to bring the economy back to equilibrium
- solves the basic economic problem

Question 4

how are resources allocated

Answer 4

through the price mechanism

Question 5

state the three main functions of the price mechanism

Answer 5

• signalling function
• rationing function
• incentivising function

Question 6

describe the signalling function

Answer 6

price sends out a signal to producers)
- e.g. Falling price signal to producers that consumer are not willing to pay that much for a g/s and they want fewer of these goods so producers should reduce the Qs

Question 7

describe the incentivising function (what will happen to incentive with falling prices)

Answer 7

Falling prices reduce incentive for producers to supply. This reduced incentive will lead to a reduction in Qs as we move back to equilibrium
vice versa

Question 7

define rationing and describe the rationing function

Answer 7

Rationing means limiting.
- At a rising price, fewer consumers are willing and able to buy at higher prices = can’t afford the g/s. This rations or limits the Qd. As a result, we see a contraction in demand moving us back towards equilibrium. The good or service is now rationed to those who can pay the higher prices

Question 8

state advantages of the price mechanism and describe them

Answer 8

• Allocative efficient. The market mechanism allows the free market to distribute goods and services efficiently without much waste
• Signals to investment. The market mechanism signals to firms and investors which goods and services are profitable and thus where they should invest and where they shouldn’t.
• No government intervention. Good and services are provided based on the invisible hand. Producers are free to produce whatever they want and consumers are free to buy whatever they want

Question 9

state disadvantages of the price mechanism and describe them

Answer 9

• market failure. no profit incentive to produce a particular good or service like healthcare = will not produce, even if there is a necessity for it or high demand.
• Wastage of resources. Most firms value profits over efficient processes and this results in waste of resources.