Price Mechanism Flashcards
What is the price mechanism?
The price mechanism is the interaction of demand and supply in a free market
This interaction determines prices which are the means by which scarce resources are allocated between competing wants/needs
What are the three functions of the price mechanism?
Rationing, signalling and incentivising
What is the rationing function?
Rationing: prices allocate (ration) scarce resources. When resources become scarcer the price will rise further. Only those who can afford to pay for them will receive them. If there is a surplus then prices fall and more consumers can afford them
What is the signalling function?
Signalling: prices provide information to producers & consumers where resources are required (in markets where prices increase) & where they are not (in markets where prices fall)
What is the incentivising function?
Incentive: when prices for a good/service rise, it incentivises producers to reallocate resources from a less profitable market to this market in order to maximise their profits. Falling prices incentivise reallocation of resources to new markets
What does Adam Smith refer to the functions of the price mechanism as
Adam Smith referred to the functions of the price mechanism as the ‘mystery of the invisible hand’
Give an example of the price mechanism in a local market
Long Island, USA has a rich history of agriculture and many producers set up farm shops selling directly to the public. In recent years, honey consumption has increased
Due to a change in one of the conditions of demand (most likely change in tastes), the demand for honey in the local market has increased from D1→D2 and the price has increased from $15 to $18
The higher price serves to ration a valuable product. Those consumers who can afford to purchase it at $18, receive it
The higher price incentivises producers to allocate more factors of production to producing honey and this is evident from the extension in supply from Q1 to Q2
The shift in demand signals to other producers that demand for honey is strong and they should consider entering the market
Give an example of the price mechanism in a national market
The T-Shirt market in the UK is highly competitive. In 2018 the price of cotton fell
Due to a change in one of the conditions of supply (a decrease in costs of production), the supply of T-shirts in the UK has increased from S1→S2 and the price has fallen from P1 to P2
The lower price increases the number of consumers who can access this product. It is rationed more widely as there is an excess in supply
The lower price incentivises consumers to purchase more T-shirts and this is evident from the increase in demand from Q1 to Q2
The shift in supply signals to other producers that there is excess supply and they should consider leaving the market
Give me an example of the price mechanism in a global market
Cash crops such as wheat, oats, barley, soy, corn, sunflowers etc. can be grown using the same factors of production
Many countries export excess crops into the world market
Producers use world prices to guide their production decisions
Farmers in France have been producing corn for many years and the market price is $2/kg. The price of potatoes in global markets has until recently been steady at $2/kg
Due to a change in one of the conditions of demand (possibly an increase in global population), the demand for potatoes has increased from D1→D2 and the price has increased from $2/kg to $3/kg
The higher price serves to ration the potatoes. Those consumers who can afford to purchase it for $3, receive it
The higher price incentivises producers to allocate more factors of production to producing potatoes and this is evident from the extension in supply from Q1 to Q2
The shift in global demand signals to producers in France that demand for potatoes is strong and they should consider switching some of their production from corn to potatoes
