microeconomics - price mechanism Flashcards
What are the four main functions of prices in the free market?
- signalling
- incentivising
- rationing
- allocating
Explain the signalling function of prices.
Prices act as signals to communicate information to decision-makers. Rising prices signal to consumers to cut back on purchases or even withdraw from the market. However, higher prices signal to producers to enter a market. Resources move or are reallocated to different industries due to this signalling function. The signalling function is associated with changes in demand and supply.
Explain the incentive function of prices.
An incentive is something that motivates consumers and producers to change their behaviour. Higher market prices of a good incentivise existing producers to increase output due to the possibility of more revenue and higher profits (assuming firms maximise profits) while a fall in prices of goods incentivise consumers to increase their quantity of the good demanded as they seek to maximise their utility.
The ‘what and how much to produce’ question of resource allocation is answered when firms produce only those goods consumers are willing and able to buy , while consumers buy only those goods that producers are willing and able to supply.
Explain the rationing function of prices.
Prices will ration the good/resource to consumers/producers who are willing and able to pay for it. When there is a shortage, market prices will increase to discourage consumption and conserve resources. Consumers or producers who are not willing or able to pay for the good/resource will then be rationed out of the market.
As consumers’ dollar votes determine what is actually produced, it will also determine what consumers can actually buy. Those who have more money can will be able to consumer more of the goods produced. This answers the resource allocation question of ‘For whom to produce?’
Explain the pursuit of self-interest.
The principle of price mechanism asserts that if each individual in society acts to maximise his own interest, the free market will assure maximum benefits to society as a whole.
In the pursuance of self-interest, consumers attempt to maximise their satisfaction by being willing to pay the lowest possible prices, while producers attempt to maximise their profits by charging the highest possible prices.
Factor owners (people who own FOPs) will attempt to maximise their earnings by selling their services to the highest bidders.
Economic agents send out and receive price signals through the market, and decisions are made based on these signals. They pursue their self-interests by engaging in a rational decision-making process that involves weighing their marginal private benefit and their marginal private cost in deciding the quantity to consumer or produce. Therefore, product and factor prices allocate resources and distribute the goods and services in a free market system addressing the problem of limited resources and unlimited wants.
What are the conditions necessary for the free market to operate efficiently?
large number of buyers and sellers, factor mobility and perfect knowledge, freedom of entry and exit and absence of externalities
Allocative efficiency occurs when…
society produces and consumes a combination of goods and services that maximises its welfare. AE is achieved when goods and services wanted by the economy are produced in the right quantities.
How does the price mechanism achieve its function of allocative efficiency?
by clearing shortages or surpluses in markets through signalling
Productive efficiency occurs when…
all resources are fully and efficiently utilised
