Price determination Flashcards
What is a product market?
Where consumers and producers meet to exchange goods and services.
What is the basic market equilibrium?
Market equilibrium is the point at which supply and demand are equal. This is also called market clearing price.
What is excess demand and how does this occur?
Excess demand is when demand is greater than supply this could lead to shortages. Excess demand occurs when prices are low and consumers are encouraged to enter the market, while producers may want to leave the market due to low potential profits.
What is excess supply and how does it occur?
Excess supply occurs when supply is greater than demand. This could occur if prices are set too high as at higher prices producers will be attracted into the market incentivised by higher potential profits, while consumers will leave the market due to the income effect.
What are the three functions of prices?
1) Rationing function: Because resources are scarce and finite, not everyone is able to buy everything they want when demand is greater than supply, then prices are bid up so that the good/ service is rationed out to those who can afford to pay.
2) Signalling function: Prices help to determine where and how resources should be allocated. For instance if prices of a particular good increase it sends a message to producers that demand is probably high and that they should increase production.
3) Incentive function: Prices help to change the behaviour of consumers and producers. For example, the government imposes high taxes on cigarettes which push up the price thus reducing the incentive of consumers to smoke.
What do prices reflect?
Not the usefulness of a good but the scarcity of it.
What is the price mechanism?
The use of prices to manipulate supply and demand and move markets to equilibrium.
What is the price mechanism for when demand increases?
1) The market is initially in equilibrium at Pe/Qe.
2) The increase in demand would initially cause excess demand at the equilibrium price of Pe. There would now be Qd demanded at price Pe but only Qe supplied.
3) The shortage of supply would signal to producers that they are able to raise their prices to try to clear the market. This should cause demand to due to the rationing effect of higher prices shown by a movement along the demand curve.
4) At the same time, supply would increase due to the incentive effect of higher prices as new suppliers are attracted into the market this is shown by a movement in the supply curve.
5) The market would eventually clear at a new equilibrium of P1/Q1. This new price would now send a signal to the rest of the economy that more resources need to be allocated to this particular market. If prices were to fall, this would send a signal to the rest of the economy that fewer resources need to be allocated to this particular market.
6) This is how the price mechanism allocates resources in a market economy.
