Price Mechanism Part 1

Question 1

Price Mechanism

Answer 1

Changes in prices, resulting from changes in demand or supply will cause resources to move in or out of industries, determines what and how much to produce, how to produce and for whom to produce

Question 2

Market Equilibrium, Equilibrium Price (Market Clearing Price)

Answer 2

Position from which there is no inherent tendency for change and achieved at a price where quantity demanded equals to quantity supplied

Price at which quantity demanded equals to quantity supplied

Question 3

Market Adjustment Process

Answer 3

1. Surplus/ shortage in the market
2. Qty supplied >/< Qty demanded
3. Downwards/ upwards pressure on price
4. Price decreases (producer sells surplus)/ price increases (consumers outbid one another)
5. Producers less/ more incentivised to produce due to fall/ rise in profitability
6. Consumers more/ less willing and able to buy
7. Qty supplied decreases and qty demanded increases/ Qty supplied increases and qty demanded decreases
8. Price reaches equilibrium price once qty supplied = qty demanded

Question 4

Demand, Supply

Answer 4

Amount that consumers are wiling and able to purchase at each given price over a given period of time (willingness to pay supported by ability to pay in effective demand)

Amount that producers are willing and able to sell at each given price over a given period of time

Question 5

Law of Demand, Law of Supply

Answer 5

Qty demanded inversely related to its price, CETERIS PARIBUS

Qty supplied directly related to its price, CETERIS PARIBUS

Question 6

Reasons for demand curve

Answer 6

1. LDMU states that beyond a certain point of consumption, each extra unit consumed gives less additional utility than previous units.
2. Being a rational consumer, consumer will maximise utility given a budget constraint and apply marginalist principle.
3. Consumer will only increase quantity demanded as price decreases, vice versa.

Question 7

Reasons for downward slope

Answer 7

1. Substitution effect (consumer will switch to/ from alternative product due to change in price ceteris paribus)
2. Income effect (Consumers’ real income/ purchase power will change and customer unable to purchase good)

Question 8

Non price determinants (definition)

Answer 8

Determine position of demand curve, change in non price determinants of demand changes quantity that consumers are willing and able to purchase at any given price

Question 9

Non price determinants of market demand that affects ABILITY to purchase goods

Answer 9

1. Income
   a. Normal good (demand for it varies directly with income)
   b. Inferior good (demand for it varies indirectly with income)
2. Government Policies
   a. Direct tax policy (affect disposable income and purchasing power)
   b. Direct subsidy policy (affect money spent, decrease cost)
3. Population (affect market size)
4. Interest Rates (affect purchasing power)
5. Exchange rates (if one currency strengthens, will be more expensive and less attractive)

Question 10

Non price determinants of market demand that affects WILLINGNESS to purchase goods

Answer 10

1. Tastes and preferences
2. Seasonal changes/ climatic changes
3. Expectations of future price
4. Prices of related good
   a. Substitutes (commodity that can be used in place of another, competitive demand with each other)
   b. Complements (good that is jointly demanded to satisfy same want)
5. Derived demand (demand for final goods and services increasing will increase demand for factors of production)

Question 11

Reasons for supply law

Answer 11

Producer experiences diminishing marginal returns in producing additional units of good X, so a higher price is required to incentivise firms to increase output and vice versa, giving rise to an upward sloping supply curve.

Question 12

Non-price determinants of supply (definition)

Answer 12

Change in non-price determinants of supply changes quantity that producers are willing and able to sell at every given price.

Question 13

Non-price determinants of supply

Answer 13

1. Cost of production
2. Innovation/ state of technology
3. Natural factors
4. Number of firms (entrance of new firms increases supply)
5. Government Policies
   a. Indirect taxes
   b. Indirect subsidy
6. Prices of Related Goods
   a. Joint supply (production of goods derived from a single product)
   b. Competitive supply (goods compete for same use of same resources, producing more of one means producing less of the other)
7. Expectations of future price changes

Question 14

Demand increase impact

Answer 14

Demand increases will raise equilibrium price and quantity, vice versa CETERIS PARIBUS (use market adjustment process to explain)

Question 15

Supply increase impact

Answer 15

Supply increases will decrease equilibrium price and quantity, vice versa CETERIS PARIBUS (use market adjustment process to explain)

Question 16

Supply and demand increase impact

Answer 16

Supply and demand increases will have indeterminate effect on market equilibrium price, equilibrium quantity will definitely be to the right. If increase in demand > increase in supply, shortage will occur (market adjustment process). If increase in supply > increase in demand, surplus will occur (market adjustment process)

Question 17

Society’s welfare (consumers’ and producers’ surplus)

Answer 17

Sum of consumers’ and producers’ surplus

Consumers’ surplus is difference between maximum amount that consumers are willing and able to pay for a given quantity of a good and what they actually pay

Producers’ surplus is difference between amount received by producers for selling their goods and minimum prices they are willing and able to accept for supplying addition units of the good.

Question 18

Functions of Price Mechanism

Answer 18

Signalling , rationing and incentive

Question 19

Signalling

Answer 19

Communicate information to decision makers (where rising prices give a signal to consumers to cut back on buying or withdraw from market completely, and signals producers to enter a market)

Results in resources moving or re-allocated to different industries, associated with changes in demand and supply

Question 20

Rationing

Answer 20

Prices ration the good/ resources to consumers/ producers who are willing and able to pay for it

Market price will increase when there is a shortage and effect is to discourage consumption and conserve resources

Consumers who are unwilling and unable to pay for the good will be rationed out of the market

Question 21

Incentive

Answer 21

Higher market prices of a good motivates existing producers to increase output due to possibility of more revenue and higher profits

Fall in price incentivises consumers to increase quantity demanded as they seek to maximise their utility

Question 22

Substitute goods

Answer 22

A substitute is a commodity that can be used in place of another and satisfies the same want, hence are in competitive demand.

Question 23

Complement products

Answer 23

Complement is a good that is used in conjunction with another and are jointly demanded to satisfy the same want, thus are in joint demand.