Price Mechanism and its Applications

Question 1

What do households’ consumption decisions give rise to?

Answer 1

Market forces of demand.

Question 2

What do firms’ production decisions give rise to?

Answer 2

Market forces of supply.

Question 3

What is a market?

Answer 3

The coming together of buyers and sellers to transact goods and services.

Question 4

How are resources allocated in a free market system?

Answer 4

According to market forces of demand and supply.

Question 5

What determines the respective prices and quantities of goods and services?

Answer 5

The level of demand and supply of each factor of production or final good/service.

Question 6

What are the characteristics for a market-based economy to allocate resources efficiently?

Answer 6

1. Perfect competition
   - Many buyers and sellers, each having an insignificant share of the market, thus none are strong enough to control the market and exploit others.
2. Rational behaviour and pursuit of self-interest
   - Consumers and producers behave rationally, self-interest drives economic activity (firms want to maximise profits, households want to maximise utility)
3. Freedom of choice and enterprise
   - Consumer sovereignty ie consumers free to decide what to buy with their income. Firms are free to decide what goods to produce and how to do so.
4. Private ownership of property
   - Individuals can own, control and dispose land, capital and natural resources, owners of FOPs have the right to income earned from the FOPs.

Question 7

What is the price mechanism?

Answer 7

It is the change in prices which causes the resources to move in and out of industries, resulting in the right mix of goods and services for society.

Question 8

What is market equilibrium?

Answer 8

A position of balance where there is no inherent tendency for change and is achieved at a point where quantity demanded equated to quantity supplied of a good at the equilibrium price level.

Question 9

What is equilibrium price?

Answer 9

The price where quantity demanded of a good equates to quantity supplied, also known as the market clearing price.

Question 10

When is a market in disequilibrium?

Answer 10

When the quantity demanded of a product does not equate to quantity supplied, resulting in shortages or surpluses.

Question 11

Explain market adjustment at prices above the equilibrium price.

Answer 11

Quantity supplied exceeds quantity demanded. To sell the surplus, producers lower the price, consumers are more willing and able to buy more, causing quantity demanded to increase. As price falls, producers are less incentivised to produce more due to fall in profitability, causing quantity supplied to decrease. This continues till equilibrium price is reached.

Question 12

Explain market adjustments and prices below the equilibrium price.

Answer 12

Quantity demanded exceeds quantity supplied. Due to shortage, consumers cannot buy as much as they want, thus they outbid each other for existing supplies as price increases, producers are more incentivised to produce more due to rise in profitability, causing quantity supplied to increase. Consumers are less willing and able to buy due to increase in price, causing quantity demanded to fall. This continues till equilibrium price is reached.

Question 13

What is demand?

Answer 13

The amount consumers are willing and able to purchase at each given price over a given period of time.

Question 14

What is the Law of Demand?

Answer 14

The quantity demanded of a good is inversely related to its price.

Question 15

Why is the individual demand curve downward sloping?

Answer 15

The individual demand curve is downward sloping due to the Law of Diminishing Marginal Utility. In maximising utility with a given budget, rational consumers would increase quantity demanded as price decreases, as marginal utility would be greater than marginal cost for more units of goods consumed, and consumers want to maximise utility and will only stop when marginal utility is equal to marginal cost.

Question 16

What is the market demand curve?

Answer 16

It is the horizontal summation of all individuals’ demand curves.

Question 17

Why is the market demand curve downward sloping?

Answer 17

It is downward sloping due to the Law of Demand. Quantity demanded is inversely related to the price due to, firstly, substitution effect, where the effect of change in price on quantity demanded arises from consumers switching to or from alternative products. Secondly, income effect, where change in price affects consumers’ real income or purchasing power which affects their ability to buy goods.

Question 18

What are the 10 non-price determinants for demand?

Answer 18

1. Taste and preference
2. Seasonal changes
3. Expectations in future prices
4. Income
5. Prices of related goods
6. Derived demand
7. Government policies
8. Population
9. Interest
10. Exchange rates

Question 19

What causes a shift in position of the demand curve?

Answer 19

Non-price determinants.

Question 20

How do tastes and preferences affect demand?

Answer 20

It influences consumers’ desired purchases and thus their willingness to purchase a good, through advertisements, education, culture, age group etc.

Question 21

How do seasonal changes affect demand?

Answer 21

It increases consumers’ willingness to purchase a good, and is a subset of tastes and preferences.

Question 22

How do expectations of future prices affect demand?

Answer 22

If consumers expect prices of the good to rise in the future, there would be more demand for it now, but if consumers expect the prices of goods to decrease in the future, they would postpone consumption of that good now, decreasing in demand.

Question 23

How does income affect demand?

Answer 23

Increase in real income affects consumers’ ability to purchase goods and services. Increase in real income causes increase in normal goods, but leads to decrease in inferior goods as consumers switch to more expensive, better quality substitutes.

Question 24

How do prices of substitutes affect demand?

Answer 24

When the prices of a substitute, a commodity that can be used in place of another and is in competitive demand with other substitutes, increases, demand for the good increases as consumers are not as willing and able to buy the substitute and thus switch their consumption to the other good.

Question 25

How do the prices of complements affect demand?

Answer 25

When the prices of a complement, a good used in conjunction with another and is in joint demand with another good, decreases, consumers are more willing and able to consume that complement and demand for it increases. Thus, the demand for the other good also increases as the two goods have to be used together. When the price of a complement increases, consumers are less willing and able to consume it and demand for it decreases. Thus the demand for the other good also decreases.

Question 26

How does derived demand affect demand?

Answer 26

Derived demand is the demand of one good that occurs due to the demand of the intermediate or final good. If the demand for final good increases, producers are incentivised to produce more of the good, and would thus need more of the intermediate good, generating higher demand for it. If the demand for the final good decreases, producers are less incentivised to produce that good, thus needing less of the intermediate good, causing the demand for the intermediate good to decrease.

Question 27

How do government policies affect demand?

Answer 27

If taxes increase, people have less disposable income, leading to a decrease in their purchasing power and ability to pay, decreasing demand for goods and services. If taxes decrease, people have more disposable income and have increased ability to pay, increasing demand for goods and services.

If subsidies, payments made by the government to consumers, are given, consumers’ ability to pay increases, hence demand for the good(s) increases.

Question 28

How does population affect demand?

Answer 28

Population affects the number of potential consumers or the size of the market. Changes in population include the increase or decrease in size or change in demographics.

Question 29

How do interest rates affect demand?

Answer 29

Interest rates are the price of borrowing money and especially affect those who rely on loans or hire purchase. if interest rates increase, cost of purchase would increase, causing consumers to be less willing and able to take out loans to buy the good, decreasing demand for the good. If interest rates decrease, cost of purchase decreases, people are more willing to take out loans to buy goods, increasing demand.

Question 30

How do exchange rates affect demand?

Answer 30

If a currency of a country appreciates, price of goods sold from that country to another will increase, causing the other country to be less willing and able to buy from the country with appreciated currency and turn to cheaper substitutes, decreasing demand for that country selling the goods. If currency for a country depreciates, price of goods sold from that country to another will decrease, causing the other country to be more willing and able to buy more goods, increasing demand.

Question 31

What is supply?

Answer 31

The quantity of a good or service that producers are willing and able to offer for sale at a given price over a given period of time.

Question 32

What is the Law of Supply?

Answer 32

The quantity of supply is directly related to the price of a good.

Question 33

Why is the firms’ supply curve upward-sloping?

Answer 33

This is due to the Law of Diminishing Marginal Returns. As firms produce more of a good, its marginal cost of production would start to increase as FOPs become less efficient. Based on the marginalist principle, to keep the producers producing with this increased cost of production, the price of the good has to increase to continue being higher than the cost of production. Thus as quantity supplied increases, price increases.

Question 34

What is the market supply curve?

Answer 34

It is the horizontal summation of firms’ supply curves.

Question 35

Why is the market supply curve upward-sloping?

Answer 35

This is due to the Law of Supply.

Question 36

What are the 7 non-price determinants for supply?

Answer 36

1. Costs of production
2. Innovation/State of technology
3. Natural factors
4. Number of firms
5. Government policies
6. Prices of related goods
7. Expectations of future prices

Question 37

How do costs of production affect supply?

Answer 37

When there is change in price factor inputs, there is changes in the level of profits. Higher profits that arise from lower costs of factor inputs, firms are more incentivised to produce more as it is more profitable, resulting in rise in supply. Lower profits due to higher costs of factor inputs, firms are less incentivised to produce more as it is less profitable, resulting in drop in supply.

Question 38

How do natural factors affect supply?

Answer 38

Favourable climatic conditions allow production of agricultural products to increase, increasing supply, while unfavourable conditions and natural disasters destroy and slow down agricultural production, decreasing supply.

Question 39

How does number of firms affect supply?

Answer 39

With entry of firms into an industry, the number of firms producing goods increases, market supply increases. When firms leave an industry, the number of firms producing goods decreases, market supply decreases.

Question 40

How do government policies affect supply?

Answer 40

When indirect taxes are imposed on expenditure of goods and services, cost of production increases, decreasing their willingness to supply more goods at every price, causing a fall in supply.
When indirect subsidy, payment made by the government to firms to produce a certain good, cost of production decreases, firms are more willing and able to supply more goods at every price, increasing supply.

Question 41

How do prices of goods in joint supply affect supply?

Answer 41

Joint supply refers to the production of goods that are derived from a single product. An increase in demand for one product will result in an increase in its price, which will encourage producers to produce more and thus supply of that good to increase. The increase in quantity supplied of this good will result in the more of the other good being offered for sale. Supply of this other good also increases. Vice versa.

Question 42

How do prices of goods in competitive supply affect supply?

Answer 42

Competitive supply refers to production of one or the other by a firm, and these goods compete for the use of the same resources. An increase in demand for one good causes its price to increase, incentivising producers to produce more of it. Thus production of this good uses up more resources, and since resources are scarce, production of the good in competitive supply decreases, and its supply decreases, and vice versa.

Question 43

How does expectations of future prices affect supply?

Answer 43

If price is expected to increase, producers may temporarily reduce the amount they sell to build up stock to release when prices increase. Thus they would currently not be willing to supply as much as they normally would. Vice versa.

Question 44

What happens when demand increases?

Answer 44

A shortage is created as demand curve shifts right, there is an increase in quantity demanded at every price level. Consumers try to outbid each other, price increases. Some consumers are less willing and able to buy the good due to income and substitution effect, quantitative demand decreases. Producers are incentivised to produce more as it is more profitable, quantitative supply increases. New higher equilibrium price and quantity is reached.

Question 45

What happens when demand falls?

Answer 45

A surplus is created as demand curve shifts left, there is a decrease in quantity demanded at every given price level. Producers reduce the price to try to clear the surplus. They are less incentivised to produce as many goods. Quantitative supply decreases. More consumers are willing and able to buy the good due to income and substitution effect. Quantitative demand increases. New lower equilibrium price and quantity is reached.

Question 46

What happens when supply increases?

Answer 46

A surplus is created as supply curve shifts right, and there is an increase in quantity supplied at every price level. Producers offer to sell the goods at a lower price, but are less incentivised to produce as much. More consumers to be willing and able to buy the good due to income and substitution effect. Quantity demanded thus increases. Equilibrium price thus decreases but equilibrium quantity increases.

Question 47

What happens when supply decreases?

Answer 47

A shortage is created as supply curve shifts left, and there is a decrease in quantity supplied at every price level. Consumers try to outbid each other, price increases. Some consumers are less willing and able to buy the good due to income and substitution effect, quantitative demand decreases. Producers are incentivised to produce more as it is more profitable, quantitative supply increases. Equilibrium price thus increases but equilibrium quantity decreases.

Question 48

What is consumers’ surplus?

Answer 48

The difference between the maximum amount that consumers are willing and able to pay for a given amount of a good and what they actually pay.

Question 49

What is producers’ surplus?

Answer 49

The difference between the amount received by producers for selling their good and the minimum prices they are willing and able to accept for supplying additional units of the good.

Question 50

What is society’s welfare?

Answer 50

The sum of consumers’ and producers’ surplus.

Question 51

What happens when society’s welfare is maximised?

Answer 51

Total economic welfare is maximised and economic efficiency is achieved.

Question 52

What are the 3 main functions of prices in the free market?

Answer 52

Signalling, rationing, incentive function.

Question 53

What is the signalling function?

Answer 53

Prices communicate information to decision-makers, for e.g., rising prices signal consumers to cut down on buying or leave a market, but signals producers to produce more and to enter a market. It allows resources to reallocate to different industries.

Question 54

What is the rationing function?

Answer 54

Prices will ration goods/resources to consumers/producers who are willing and able to pay for it, for e.g., high prices will discourage consumption and conserve resources, consumers/producers who are unwilling and unable to pay will be rationed out of the market.

Question 55

What is the incentive function?

Answer 55

Prices motivate a consumer/producer to change their behaviour. Higher prices motivate existing producers to increase production due to the possibility of higher profits. Lower prices motivate consumers to increase the quantity demanded of a good as they seek to maximise utility.

Question 56

How do prices answer “what and how much to produce”?

Answer 56

Firms produce goods that consumers are willing and able to buy, consumers buy goods that producers are willing and able to supply.

Question 57

How do prices answer “how to produce”?

Answer 57

For given resource prices, firms will use the best combination of resources to produce a given output at the lowest possible cost.

Question 58

How do prices answer “for whom to produce”?

Answer 58

Those with more money will be able to consume more of the goods produced.

Question 59

What is economic efficiency?

Answer 59

The best possible use of resources, achieved when both allocative and productive efficiencies are achieved in an economy.

Question 60

How does the price mechanism achieve allocative efficiency?

Answer 60

It does so by clearing shortages and surpluses through signalling. When prices change, it signals to consumers and producers that there is either a shortage or surplus, and incentivises them to change their behaviour, such that there is reallocation of resources, a new equilibrium price and quantity is reached and allocative efficiency is achieved. This answers ‘what and how much to produce’, and ‘for whom to produce’ (consumers with more money/with not as much money).

Question 61

How does the price mechanism allow for productive efficiency?

Answer 61

The adjustment of factor prices acts as a signal and incentive for producers to adjust how much of each resource to use and their production methods, in deciding the least costly method of production.

Question 62

Why is the free market not desirable?

Answer 62

Efficiency can only be achieved under very strict conditions which are difficult to meet in the real world.
Those with more dollar votes will be able to consume more goods produced, resulting in unfair distribution of goods and inequity.

Question 63

What is allocative efficiency?

Answer 63

The situation in which the society produces and consumes a combination of goods and services that maximises its welfare, achieved when goods and services wanted by the economy are produced in the right quantities.

Question 64

What is productive efficiency?

Answer 64

The situation in which all resources are fully and efficiently used.