Price and the Allocation of Resources

Question 1

You need to know about Competitive Markets

Answer 1

1. Competitive markets exist under certain conditions:
   - When there are a large number of buters and sellers
   - 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
2. In a competitive market it’s assumed that consumers an producers act rationally:
   - 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.

Question 2

Price is the main way of Allocating Resources in a Market economy

Answer 2

1. The value at which a good or service is exchanged is known as its price. Changes in demand or supply of a good/service lead to changes in its price and to the quantity bought/sold - this is known as the price mechanism.
2. The price mechanism allocates goods/services in an impersonal way, as prices change until equilibrium is achieved and supply equals demand. It’s free from people’s biases and opinions. The price mechanism also coordinates the decisions of buyers and sellers e.g. how expensive something is will influence whether someone buys it and how much of it a producer supplies.
3. The price mechanism has the following three functions:
   - It acts as an incentive to firms - higher prices allow firms to produce more goods/ services and encourage increased production and sales by providing higher profits.
   - It acts as a signalling device - changes in price show changes in supply and/or demand and act as a signal to producers and consumers. E.g. a price increase is a signal to producers that demand is high, so this will encourage them to increase production.
   - It acts to ration scarce resources - if there’s high demand for a good/service and its supply is limited, then the price will be high. Supply of the good will be restricted to those who can afford to pay a high price. The opposite applies for goods that are in low demand but in high supply - they’ll have a low price and many will be sold.
4. The price mechanism is also used to allocate the resources used to produce goods/services. E.g. if demand for curtains increases, the market will allocate more curtains to consumers, more labour for making curtains, and more commodities (e.g. cotton) to curtain manufacturers.

Question 3

The Price Mechanism has advantages and disadvantages

Answer 3

Advantages:

1. Resources will be allocated efficiently to satisfy consumers’ wants and needs.
2. The price mechanism can operate without the cost of employing people to regulate it
3. Consumers decide what is and isn’t produced by producers
4. Prices are kept to their minimum as resources are used as efficiently as possible

Disadvantages:

1. Inequality in wealth and income is likely
2. There will be an under-provision of merit goods and an over-provision of demerit goods, as the supply of and demand for these goods won’t be at the socially optimal level.
3. People with limited skills or ability to work will suffer unemployment or recieve very low wages
4. Public goods won’t be produced

Introducing the price mechanism into an area of human activity can have unintended consequences. For example, offering payment for blood donations can reduce the supply of blood donors - donors often have altrusitic reasons for giving blood and are uncomfortable about recieving payments. Another disadvantage of payments forblood donations is an increase in the cost of screening required to prevent ‘unsuitable’ donors (e.g. drug users) donating.