Price Mechanism and Its Applications (DD/SS) Flashcards
Explain the assumptions of the market
Consumers of final goods/services and their consumption decisions give rise to the market forces of demand. Firms are producers of goods/services, and their production decisions give rise to the market forces of supply. The coming together of buyers and sellers to transact goods and services is known as a market. In a free market system, resources are allocated according to the market forces of demand and supply.
1) Perfect competition - many buyers and sellers, each having an insignificant share of the market and none are strong enough to control or exploit the market
2) Rational behaviour and the Pursuit of Self-Interest - Rational producers or firms try to maximise profits, while rational consumers try to maximize utility as they are driven by self-interest.
3) Freedom of choice and enterprise - Consumers are free to decide what to buy with their incomes (Consumer sovereignty) and firms are free to choose what to sell and what production methods to use.
4) Private ownership of property - Individuals have the right to own, control and dispose of land, capital and natural resources, Owners of FOP have the right to the income earned (rent, interest, profits) from the use of these FOPs.
Define demand and supply.
Demand refers to the amount that consumers are willing and able to purchase at each given price over a given period of time.
Supply refers to the quantity of a good or service that producers are willing and able to offer for sale at each given price over a given period of time.
Explain why the demand curve is downward sloping and how the marginalist principle explains the consumers’ behaviour.
The market demand curve is downward sloping due to the Law of Demand, which states that the quantity demanded of a good/service is inversely related to its price, ceteris paribus (will increase Qdd as price decreases) and the Law of Diminishing Marginal Utility (LDMU) which states that beyond a certain point of consumption, each extra unit consumed gives less additional utility than previous units/marginal utility of consuming additional units of good X is decreasing.
Consumer should purchase an additional unit of good X if its MU is equal to or more than the price of the good as doing so will allow the consumer to become better off as he can derive utility that exceeds the amount he has spent.
Consumer should not purchase an additional unit of good X if its MU is less than the price of the good as doing so will make the consumer worse off as the amount he spends exceeds the utility he is able to derive from consuming the good.
Explain why the supply curve is upward sloping and how the marginalist principle explains the producer’s behaviour.
The market supply curve is upward sloping due to the Law of Supply, which states that the quantity supplied is directly related to the price of a product, and the law of diminishing marginal returns (LDMR) which states that beyond a certain point of production, adding an additional factor of production results in smaller increases in output. Hence, profit-maximising firms which experiences increasing marginal costs will only sell additional units of goods when prices increase as the profitability of doing so increases.
Producer should produce an additional unit of good X if its price is equal to or more than its MC of production as doing so will allow the producer to become better off as profits increase.
Producer should not produce an additional unit of good X if its price is less than its MC of production as doing so will make the producer worse off as profits decrease.
Distinguish effective demand from demand.
For demand to be effective, the willingness to pay must be supported by the ability to pay.
Explain how changes in the non-price determinants of demand/supply can lead to a shift in the market demand/supply curve
A change in the non-price determinants of demand changes the quantity that consumers are willing and able to purchase at any given price. Graphically, this is represented by a shift of the demand curve. When demand decreases, the curve shifts left and when demand increases, the curve shifts right.
Factors influencing market demand
1) Tastes and preferences
2) Seasonal changes/Climate changes (a subset of 1)
3) Expectations of future prices
4) Income
5) Prices of related goods - substitutes and complements
Substitutes satisfy the same want and are in competitive demand. A rise in price of the good will result in a rise in demand for its substitute. Complements are used in conjunction with another and are in joint demand/jointly demanded to satify the same want. A fall in price of the good will result in an increase in demand for the complement.
6) Derived demand refers to the demand for one good or service that occurs as a result of the demand for another intermediate/final good or service. Changes in the final product market will cause the demand for factor resources to change because the demand for factors of production is derived from the demand for final goods and services.
7) Government Policies such as direct tax policy reduces the disposable income, purhcasing power and henece demand for normal goods and services. Direct subsidies increase the consumers’ ability to pay and hence demand.
8) Population changes affect the number of potential customers or the size of the market. For instance, ageing population will result in an increase in the demand for healthcare services.
9) Interest rates are the price of borrowing money. An increase in interest rates will reduce the demand for goods as the cost of purchase increases even though the price of the good remains the same. This is especially for those who rely on loans or hire purchase.
10) Exchange rates affect foreign demand for a country’s goods and services.
A change in the non-price determinants of supply changes the quantity that producers are willing and able to supply at any given price. Graphically, this is represented by a shift of the supply curve. When supply decreases, the curve shifts left and when supply increases, the curve shifts right.
Factor influencing the market supply
1) Cost of production: If the price of raw materials/fuel/power/cost of labour/cost of capital rises, the cost of producing the good X will increase, causing production to be less profitable. The firm will only be willing to supply fewer cars at each given price. The supply of cars will shift leftwards from S0 to S1 quantity demanded decreases OQ0 to OQ1.
2) Innovation/State of Technology: Refers to the economy’s stock of knowledge about how the resources can be the most efficiently combined. As a result of advancements in technologies, this will increase the productivity of the factors of the production and each unit of a factor will be able to produce more now. With the same factors price, cost per unit of output will be lower, ceteris paribus. The producers will be able and willing to supply more of the good at each and every given price level and the supply curve shifts to the right from S0 to S1 quantity demanded decreases OQ0 to OQ1.
3) Natural factors: Assuming that there are no changes in the cost of production, favourable climatic conditions will shift the supply curve to the right. Occurrence of natural disasters will reduce the supply of agricultural production leading to a leftward shift in the supply curve.
4) Number of firms: With the entry of new firms, the supply increases leading to a rightward shift of the supply curve.
5) Government policies: Indirect taxes increase the COP, firms will only be willing and able to supply fewer goods at every price, leading to a fall in supply and leftward shift of the supply curve. Indirect subsidies reduce the firms cost of production…
6) Prices of related goods: In Joint supply, where two or more products refer to the production of goods and services that are derived from a single product. It is not possible to produce more of one without producing more of the other (i.e. Qss increases causes supply of the other good to increases). The competitive supply of two or more products refers to the production of one or the other by a firm as the goods compete for the use of the same resources and producing more of one means producing less of another (i.e. Qss increases cause supply of the other good to decrease)
7) Expectations of future prices: If the price is expected to rise, producers may temporarily reduce the amount they sell in the market and are likely to build up stocks and only release them on to the market when the price does rise (i.e. supply curve shifts left)
Define and identify market equilibrium
Market equilibrium is a situation in which buyers and sellers are on aggregate satisfied with the current combination of price and quantity of a good bought or sold and are under no incentive to change their present economic actions. It is the point where demand interests supply and the quantity demanded and supplied are equal at the equilibrium price level.
Explain the price adjustment process
At prices above Pe, there is a surplus in the market since quantity supplied exceeds the quantity demanded resulting in downward pressure on the price. To sell their surplus, producers will begin to lower prices. As prices fall, consumers are willing and able to buy more due to income and substitution effects, causing the quantity demanded to increase. As price falls, producers will also be less incentivised to produce due to a fall in profitability.
At prices below Pe, there is a shortage in the market since quantity demanded exceeds the quantity supplied resulting in upward pressure on the price. This puts upward pressure on price as consumers will try to outbid one another for existing supplies. As prices increase, producers are willing and able to supply more due to an increase in profitability. Consumers will also be willing and able to buy less due to the increase in price, causing Qdd to fall. This increase in price continues until the eqm price is reached where Qdd equals Qss.
Define and illustrate consumer/producer surplus in a diagram. Define society’s welfare.
Society’s welfare is the sum of consumers’ and producers’ surplus.
Producer surplus is the difference between the amount received by producers for selling their good and the minimum prices that they are willing and able to accept for supplying additional units of the good.
Consumer surplus is the difference between the maximum amount that consumers are willing and able to pay for a given quantity of a good and what they actually pay. It is also a measure of consumer welfare.
What are the 3 fundamental questions of resource allocation? What are the functions of the price mechanism? How does price mechanism answer them?
The price mechanism refers to the way prices in a free market play the signalling, incentive and
rationing functions to allocate scarce resources in a free market by clearing shortages and surpluses
and addressing the three questions of resource allocation: what and how much to produce, for whom
to produce and how to produce.
The market demand curve is downward sloping due to the Law of Demand, which states that the price
and quantity demanded of a good are inversely related. The market supply curve is upward sloping
due to the Law of Supply and the Marginalist Principle as increasing prices increases the profitability
of selling additional units of goods.
As seen in Figure 1, natural factors such as favourable growing conditions – plenty of sun, rain and good
weather conditions – lead to a rise in the supply of cabbage and the supply curve shifts from S0 to S1 in
Figure 1. This then leads to a surplus that creates a downward pressure on prices which signals to
consumers and producers that there is a surplus in the market of QsQ0 and causes prices to start falling
as producers begin to lower prices so as to attract more customers to buy the cabbage. The falling
prices serves as an incentive to consumers to increase their quantity demanded along the demand
curve as real incomes increase and other substitutes to cabbage like spinach may become relatively
more expensive and hence not preferred. The falling prices also is a disincentive to producers who
will decrease their quantity supplied as lower prices mean lower profitability and hence producers are
less willing and able to make the same amount of cabbage available for sale, hence quantity supplied
falls. This process continues until the new equilibrium is reached at E1 where the price of cabbage has
fallen to P1 and quantity traded in the market increases to Q1. Hence the surplus is eliminated and
the right amount of scarce resources is allocated to produce the right amount of good at equilibrium
quantity of Q1, thus answering the question of what and how much to produce. The price mechanism
also plays a rationing function by making the good available only to those who are willing and able to pay the new price at P1, hence answering the question of for whom to produce.
In conclusion, the price mechanism allocates scarce resources in the market for cabbage in Taiwan
through the price adjustment process by serving signaling, incentive and rationing functions such that
the right amount of the good is produced.
