Price Mechanism

Question 1

Functions

Answer 1

-The price mechanism determines the market price. Adam Smith called this ‘The invisible hand of the market’.

-Resources are allocated through the price mechanism in a free market economy. The economic problem of scarce resources is solved through this mechanism. The price moves resources to where they are demanded or where there is a shortage, and removes resources from where there is a surplus.

Question 2

Three main functions to allocate resources

Answer 2

-Rationing-When there are scarce resources, price increases due to the excess of demand. The increase in price discourages demand and consequently rations resources. Eg plane tickets might increase in price as they run out-rationing out the plane tickets.

-Incentive-This encourages a change in behaviour of a consumer or producer. For example a high price would incentivise producers to supply more because it is more profitable.

-Signalling-The price acts as a signal to consumers and new firms entering the market. The price changes show where resources are needed in the market. A high price signals firms to enter the market because it is more profitable. However, this encourages consumers to reduce demand and therefore leave the market. This shifts the demand and supply curves.