Micro 4 - Price mechanism and economic systems Flashcards
What are markets?
Markets are a way of allocating resources They don’t have to be a place or involve the exchange of physical goods
What does each buyer or seller in a market choose to exchange something they have for?
Something they’d prefer to have instead
Since everyone is considered to be rational in a free market what would an economist assume?
- The worker would prefer to have their wages but less free time
- The employer would prefer to have less money and to know that there’s someone there to do some work
Why can any exchange happen in the first place?
Any exchange can only happen because different people or organisations value things differently
What do mixed economies combine?
Free markets and government intervention
What is a free market?
A free market allocates resources based on supply and demand and the price mechanism. In other words anything can be sold at any price people will pay for it.
What is a command economy?
In a command economy it is the government that decides how resources should be allocated.
What is a command economy?
In a command economy it is the government that decides how resources should be allocated.
What type of countries have command economies?
Communist countries have command economies but they are much rarer since the collapse of communism in the late 20th century.
When does market failure happen?
Market failure happens when free markets results in undesirable outcomes
What might governments do when they intervene due to market failure?
- They might change the law or offer tax breaks or create some other kind of incentive to try and influence people’s behaviour
- Governments can also intervene in the economy by buying or providing goods or services
What is it called when both the government and markets play a part in allocating resources?
A mixed economy
How many sectors are there in a mixed economy?
3
What are the three sectors in a mixed economy?
- The public sector
- The private sector
- The voluntary sector
What does the public sector in a mixed economy include?
The government is known as the public sector
What does the private sector in a mixed economy include?
Businesses that are privately owned make up the private sector
What does the voluntary sector in a mixed economy include?
The voluntary sector includes charities and other non-profit making organisations
In a pure free market economy which sector would not exist?
The public sector
In a pure command economy which sector would not exist?
The private sector
What time period did Adam Smith live in?
The 18th century
What time period did Karl Marx live in?
The 19th century
What time period did Friedrich Hayek live in?
The 20th century
What have Adam Smith’s ideas shaped?
Traditional economic theory
What was Adam Smith a big believer in and what did he say about it?
Adam Smith was a big believer in the free market and described how its invisible hand would allocate resources in society’s best interests
How did Adam Smith say that the invisible hand of the market came about?
He said that it came about because consumers and producers are motivated by self interest - consumers are motivated to maximise their own benefits and producers are motivated to maximise profit. In a free market consumers demand and producers supply will lead to price levels being set at a point which benefits them both
What did Adam Smith say there needed to be for the free market to work properly?
There couldn’t be any monopolies and there would have to be low barriers to entry to maximise competition
As well as the free market what else did Adam Smith also write about?
Specialisation and the division of labour
What was Karl Marx critical of and why?
Karl Marx was critical of the free market and argued that it created a situation where a small ruling class of producers known as the bourgeoisie dominated and exploited the larger working class of wage earners called the proletariat
What did Marx argue about bourgeois producers?
Marx argued that the profit-maximising bourgeois producers would exploit workers for example by paying them low wages and giving them few rights until the proletariat eventually rose up in a revolution and took over. This would then lead to the workers controlling production and everyone having a share of ownership of resources
What did Marx’s ideas lead to the rise of?
Marx’s ideas led to the rise of communism in the 20th century but his ideas contained little about how command economies would work. Many communist countries collapsed in the late 20th century which led to the discrediting of communism and command economies but Marx’s ideas are becoming more popular now
What was Friedrich Hayek a supporter and a critic of?
Friedrich Hayek was a keen supporter of the free market system and a critic of command economies. He argued that governments shouldn’t intervene to allocate resources because governments lack the information required to allocate them in the way that is most beneficial to society
What did Hayek believe about individual consumers and producers?
Hayek believed that individual consumers and producers have the best knowledge of what they want or need and so the allocation of resources should be left to them and the price mechanism
What did Hayek see the price mechanism as a way of?
Hayek saw the price mechanism as a way for producers and consumers to communicate, this is the idea of price acting as a signalling device between consumers and producers. The price level set by the forces of supply and demand would show what both consumers and producers want and will naturally allocate resources in a much more efficient way than governments can
When is a market in equlibrium?
When supply equals demand
At equilibrium what is the relationship between price and output?
At equilibrium, price and output are stable. There is a balance in the market and supply is equal to demand. All products that are presented for sale are sold and the market is cleared
In a free market what determines the equilibrium price and quantity?
Supply and demand
What is the free interaction of supply and demand determining the equilibrium price and quantity in a free market called?
Market forces
Where can the equilibrium point on a supply and demand diagram be found?
It can be found at the point where the supply curve and demand curve meet
Define disequlibrium
When supply and demand aren’t equal the market is in disequlibrium
If there is excess supply or demand what will the market be in?
Disequilibrium
What do market forces do?
Market forces act to remove excess supply or demand
When does excess supply occur?
Excess supply is when the quantity supplied to a market is greater than the quantity demanded
When does excess demand occur?
Excess demand is when the demand for a good/service is greater than its supply
What effect will shifts in demand or supply curves have on market equilibrium?
It will change the market equilbrium
Will price inelastic supply or demand have a greater impact on price or quantity of the shifts of demand or supply curves?
Price
Will price elastic supply or demand have a greater impact on price or quantity of the shifts of demand or supply curves?
Quantity
What does price elasticity of supply and price elasticity of demand influence the size of change of?
Changes in the equilibrium price and quantity caused by supply and demand curve shifts
Under what conditions do competitive markets exist?
- When there are a large number of buyers (consumers) and sellers (producers)
- When no single consumer or producer can influence the allocation of resources by the market or the price that goods and services can be bought at
What is assumed about consumers and producers in a competitive market?
That they act rationally
How do consumers and producers act rationally in a competitive market?
- Consumers aim to maximise their welfare by buying goods/services to maintain or improve their quality of life
- Producers compete to provide consumers with what they want at the lowest possible price so they can maximise their profit by selling to the most customers
What is the main way of allocating resources in a market economy?
Price
Define price
The value at which a good or service is exchanged is known as its price
Define the price mechanism
Changes in the demand or supply of a good or service leads to changes in its price and to the quantity bought/sold. This is known as the price mechanism
Explain how the price mechanism allocates goods and services
The price mechanism allocates goods/services in an impersonal way known as the invisible hand of the market, as prices will change until equilibrium is achieved and supply equals demand. Its free from people’s biases and opinions.
The price mechanism also coordinates the decisions of buyers and sellers. For example how expensive something is will influence whether someone buys it and how much of it producers supply
What are the three functions of the price mechanism?
- An incentive device
- A signalling device
- A rationing device
Explain how the price mechanism can act as an incentive device
The price mechanism acts as an incentive device - higher prices allow firms to produce more goods and services and encourages increased production and sales by providing higher profits
Explain how the price mechanism can act as a signalling device
The price mechanism acts as a signalling device as changes in price shows changes in supply and/or demand and act as a signal to producers and consumers. For example a price increase is a signal to producers that demand is high so this will encourage them to increase production
Explain how the price mechanism can act as a rationing device
The price mechanism acts as a rationing device as if there is high demand for a good or service and its supply is limited then the prices will be high. Supply of the good will be restricted to those that can afford to pay a high price.
The opposite applies for goods that are low in demand but in high supply, they will have a low price and many will be sold.
Apart from its 3 main functions how else is the price mechanism used?
The price mechanism is also used to allocate the resources used to produce goods and services. For example if demand for curtains increases the market will allocate through the price mechanism more curtains to consumers, more labour for making curtains and more commodities to curtain manufacturers.
What are the advantages of the price mechansim?
- Resources will be allocated efficiently to satisfy consumer’s needs and wants
- The price mechanism can operate without the cost of employing people to regulate it
- Consumers decide what is and isn’t produced by producers
- Prices are kept to their minimum as resources are used as efficiently as possible
What are the disadvantages of the price mechanism?
- Inequality in wealth and income is likely
- People with limited skills or ability to work will suffer unemployment or receive very low wages
- Public goods won’t be produced
What effect can introducing the price mechanism into an area of human activity have?
Introducing the price mechanism into an area of human activity can have unintended consequences
What are the advantages of a free market economy?
1- There will be increased efficiency as only products of the best value will be in demand giving firms an incentive to make goods and services as efficiently as possible
2- In a free market economy rewards for good ideas can make entrepreneurs lots of money encouraging innovation and risk taking
3- The incentive for innovation can lead to increased choice for consumers and in a free market consumers are not restricted to buying what the government recommends
What are the disadvantages of a free market economy?
1- Free market economies can lead to huge differences in income which can lead to inequality. Also people unable to work would receive no income
2- Non-profitable goods would not be made such as medicines to treat rare conditions as they would not sell enough to make profits for firms
3- Monopolies are likely to form as successful businesses may become the only supplier of a good and this market dominance could be abused.
What are the advantages of a command economy?
1- Governments can maximise welfare by preventing inequalities and redistributing incomes fairly. They can also ensure the production of beneficial goods to society
2- The government can try to keep unemployment low by providing everyone with a job and salary
3- The market dominance of monopolies can be prevented by the government
What are the disadvantages of a command economy?
1- A lack of information could mean that the government make poor and slow decisions about what needs to be produced
2- Consumers may have limited choice in what they can consume as firms will only make what they are told to make
3- Government-owned firms have no incentive to increase efficiency or take risks or innovate as they have no profit motive
