Micro 5 - Price Equilibrium and the Market Mechanism Flashcards
What are the two types of economy?
- Command economy.
2. Free market economy.
What type are most economies?
> Mixed economies that combine features of the two.
>In reality there are no pure free markets or command economies.
How to resolve fundamental economic problem
> Economists are faced with the fundamental economic problem of how to allocate scarce resources.
Economic theory distinguishes between two distinct ways of resolving this question: either through establishing a centrally planned command economy or allowing a free market economy with very limited government intervention.
Features of a command economy in the UK
>Tax. >Roads. >Police. >Army. >NHS. >Education.
Features of a market economy in the UK
> Privatisation.
Strengths of a command economy
> More equality.
Avoids market failure.
Consumers, labourers and environment need protection.
Strengths of a market economy
> More freedom.
Weaknesses of a command economy
> Drives away investors.
No freedom.
Too many things for the government to be able to control them all properly.
Corruption.
Weaknesses of market economies
> Extreme inequality (extreme poverty).
>Exploitation.
Which is the best way to achieve allocative efficiency?
> The free market and the forces of supply and demand are the most effective methods of achieving allocative efficiency and meeting people’s wants and needs.
This approach is often described as the laissez-faire approach to economic decision making and allocation of resources.
Market equilibrium - definition
> 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 nor shortage of the good or service.
Surplus - definition
> When producers produce more of a good or service than can be sold at the current price levels otherwise known as excess supply.
Shortage - definition
> 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.
Disequilibrium - definition
> 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 always do?
> Stabilise itself.
Surplus = price drops.
Shortage = competition drives up prices until pressure relieves and equilibrium is reached.
What will the market tend towards?
> It is believed that the market will 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.
This price and quantity will remain the same unless there is an ‘outside disturbance’ that will influence price or quantity consumed.
Shifts in demand, supply and relation with price
> 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.
Price is said to have a number of functions in enabling efficient allocation of resources.
List of functions price has in enabling efficient allocation of resources
- Signalling.
- Incentivisation.
- Rationing.
- Allocation.
Price - signalling
> Price changes to signal to both producers and consumers that they ought to change their behaviour.
A price rise signals to producers that they will be able to make more of a product and continue to make 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 goods for another which is no longer able to provide as much utility for their money.
Price - incentivisation
> A price rise provides an incentive for producers to make the sacrifices (incurring an OC 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 them to producers facing increased demand.
Price - rationing
> Price rises often occur due to rising scarcity of resources and a consequent fall in supply.
Or, suppliers may not be equipped to deal with a large rise in demand so will have to pay increased prices.
These price rises ensure only those willing and able to pay the most will receive the resources.
Price - allocation
> There are scarce resources available and the fundamental economic problem states that we must decide how to use them.
The above function will help us determine how to allocate resources.
Market mechanisms
> Market mechanisms and arrival at a new market price and output equilibrium use signalling, incentivisation, rationing and allocation.
Also use costs, utility, income and substitution effect.
Allocatively efficient.
> Production and distribution of goods and services in such a way that best satisfies the needs and wants of consumers.
Most utility.
One more unit = more utility than disutility.
Market economy and allocatively efficiency
> Market economies maximise utility as producers supply to consumer demand but government allocates resources in a command economies.
Price Elasticity of Demand - definition
> The responsiveness of quantity demanded of a good to changes in price.
Elastic Demand - definition
> Demand where a percentage change in price causes a greater percentage change in quantity demanded.
Inelastic Demand - definition
> Demand where a percentage change in price causes a lower percentage change in quantity demanded.
Perfectly Elastic Demand - definition
> Demand with an infinite PED represented by a horizontal line.
Perfectly Inelastic Demand - definition
> Demand with a PED of 0, for which a change in price causes no change in quantity demanded.
Unitary Elastic Demand - definition
> Where a percentage change in price causes the same percentage change in quantity demanded.
Unitary PED = 1.
Price Elasticity of Supply - definition
> Responsiveness of quantity supplied of a good to a change in price.
PED formula
> (% change in Qd)/(% change in price).
>Always a negative number.
Elastic demand - number
k < -1.
Inelastic demand - number
-1 < k < 0.
Revenue - definition
> Total amount of money a firm receives from sales over a given period of time.
P x Q = simple formula.
Revenue and PED
> If PED is known, a firm can determine revenue if prices are changed.
Indirect tax - definition
> Tax taken from producers that is passed on to the consumer in the price of the good they are purchasing.
E.g. VAT.
Purposes of indirect tax
> Indirect taxes have 2 purposes:
- Raising revenue for government.
- Reducing consumption of demerit goods. However, whether these purposes are successfully achieved depends upon PED.
Reasons for elastic demand
- There are many close substitutes of the good available.
- The price of the good constitutes a high proportion of people’s income.
- The price change is perceived to be permanent.
- The good is defined by very narrow terms.
Reasons for inelastic demand
- The good is considered to be an essential item.
- Consumers of the good have a high degree of brand loyalty.
- Consumers lack complete information about the rice and quality of substitutes.
- The price change is perceived to to only be short term.
- The good is defined by very broad terms.
- It is time consuming or costly to switch products.
PES formula
> (% change in quantity supplied)/(% change in price).
>Always positive.
Elastic supply
PES > 1.
Inelastic supply
0 < PES < 1.
Unit elasticity of supply
PES = 1.
Perfectly elastic supply
infinite
Perfectly inelastic supply
0
Reasons for elastic supply
- The firm/industry has high levels of spare capacity.
- Firm’s suppliers have high PES.
- Output is mostly provided on large scale, industrial production lines.
- Factors of production in the industry can be easily sourced and mobilised.
Reasons for inelastic supply
- The industry requires specialised, highly skilled labour.
- There are large numbers of unemployed workers suited to the industry.
- The firm suffers from rapidly diminishing marginal product of labour.
- The product takes a relatively long time to be created (long production cycle).
- PES is being measured over a shorter time period.
- The country the industry is based in has strict immigration controls.
