Micro 5: Price Equilibrium and the Market Mechanism Flashcards
What are the most effective methods of achieving allocative efficiency and meeting people’s wants and needs?
The free market and the forces of supply and demand. This is often described as a laissez-faire approach to economic decision making and allocation of resources.
What happens in the market if the price is set below the equilibrium and why?
The quantity demanded is greater than quantity supplied because consumers are happy with the low price and want to buy more of the product but producers are only willing to supply a certain amount of that product for a low price as their profit will not be high. So acts as signal for price to rise until equilibrium is met because buyers compete to get the limited available units by offering more money. It also rations the scarce resources so contraction along demand curve.
What is market equilibrium?
The price and quantity produced present in the market of a good or service where all goods produced are sold and there is neither a surplus or shortage of the good or service.
What is a surplus?
When producers produce more of a good or service than can be sold at current price levels, otherwise known as excess supply.
What is a shortage?
When consumers are willing and able to buy more of a good than is being produced at current price levels, otherwise known as excess demand.
What is disequilibrim?
A condition where the market is not operating at equilibrium price and quantity and there is an excess supply or demand.
What does the market tend towards?
Equilibrium price and quantity. This means producers and buyers will work towards the ‘clearing price’ for a good or service, where all goods produced or services provided are sold.
The price and quantity will remain the same unless what happens?
Unless there is an ‘outside disturbance’ that will influence price or quantity consumed. The most common disturbances will be changes in demand or supply which will cause either curve to shift and bring about an extension or contraction along the opposing curve. Whenever there is a shift in demand or supply there is going to be a change in price and this change in price acts as a means of helping the market allocate resources.
What are the functions of price that enable efficient allocation of resources?
Signalling, incentivisation, rationing and allocation.
What is signalling?
Price changes signal to both producers and consumers that they ought to change their behaviours. A price rise signals to producers that they will be able to produce more of a good and continue to make a profit (despite potentially higher marginal and average costs). A price fall signals to the consumer that they should buy more of something in order to maximise their utility, perhaps substituting this good for another which is no longer able to provide the most utility for their money.
What is incentivisation?
A price rise provides an incentive for producers to make the sacrifices (incurring an opportunity cost or even disutility) required to increase their output of a good or service in order to meet higher demand. This in turn can be passed on to those who provide producers with factors of production to provide more of those factors to the producers who are facing increased demand. Eg. if consumers are willing and able to pay more for building work, the higher price will incentivise builders who would otherwise have taken the day off or gone on holiday to get out of bed and go to work. The income they earn is greater in value to them than the opportunity cost of whatever it is they are sacrificing.
What is rationing?
Price rises often occur due to increasing scarcity of resources and a consequent reduction in supply. Similarly, suppliers may not be equipped to deal with a large increase in demand and will have to significantly increase prices. These price rises will ensure that only those who are willing and able to pay the most for the resources (and in theory value the resources the most) will receive those resources.
What is allocation?
There are scarce resources available and the fundamental economic problem states that we must decide how to use them. The other functions will help us determine how to allocate resources. Eg. a dairy farmer has limited milk to sell and the milk can be put to multiple uses. If people’s tastes change and they begin to enjoy yogurt more and turn away from cheese, then demand for yogurt will increase and demand for cheese decreases. This means the dairy farmer will respond to the increased price of yogurt and decreased price of cheese by allocating more of his milk towards the production of yogurt and less towards the production of cheese. Again, if people are willing to pay more for a gallon of milk used in yogurt than a gallon of milk used in cheese then this would suggest that the utility they derive from yogurt is greater than the utility they derive from cheese, so it makes sense to allocate the scare milk this way.
What is productive efficiency and where is it met on a PPF diagram and on a cost curves diagram?
Where the resources are being used most effectively to derive the highest output per factor input. This is where factor inputs are most productive and should be where cost per unit is minimised.
PPF- on the curve
cost curve- where marginal costs cross average costs
When is an economy allocatively efficient?
When it is producing and distributing goods and services in such a way that best satisfies the needs and wants of consumers.
What do price rises cause along the supply curve?
An extension.
What does a fall in price cause along the supply curve?
A contraction.
What is price elasticity of demand (PED) and price elasticity of supply (PES)?
The responsiveness of quantity demanded and quantity supplied of a good or service to changes in price.
What does ‘price elastic’ mean?
If quantity demanded or supplied is particularly responsive to price changes then demand and supply are said to be ‘price elastic’.
