Topic 5.1 How markets and prices allocate resources

Question 1

Price mechanism

Answer 1

The way in which prices are determined through forces of supply and demand

Question 2

How to find disequilibrium

Answer 2

Extend the line from P1 to the new shifted curve

Question 3

Functions of the price mechanism

Answer 3

Prices…
Allocate (4)
Ration (3)
Signal (1)
Incentive (2)

Question 4

Allocative efficiency

Answer 4

Allocative efficiency occurs where consumer satisfaction is maximised due to the production of goods and services.

Question 5

Analysis of Price Mechanism when demand is shifted to the right

Answer 5

• Extending the line from P1, to get Q3. Q1 to Q3 is the excess demand. This causes prices to rise (to P2).
• This rise in price signals that there is excess demand within the market.
• This then incentivises firms to produce more of the good because they can make more profit - this incentive function can be seen in an expansion in supply
• This consequently causes a contraction along the demand curve and rations scarce resources because higher prices attract less quantity demanded
• This results in Q2 being demanded which is in equilibrium with P2 (as S1 = D2) therefore the market allocates scarce resources efficiently.

Question 6

Analysis of price mechanism when supply is shifted to the right

Answer 6

• Extending the line from P1 to the new supply curve, we have Q3 supplied. This is greater than Q1 demanded therefore, we have excess supply. This causes prices to decrease in order to sell left over stock.
• This decrease in price signals to the market that there is excess supply of that good/service.
• This incentivises producers to decrease their production of that good/service as they are making less profit producting goods/services at the lower price (a contraction in supply) to Q2
• This rations scarce resources (in this context, increases consumption) due to the fall in price causing an expansion along the demand curve to Q2.
• Here demand = supply and we have acheived allocative efficiency at P2Q2.

Question 7

Productive efficiency

Answer 7

Where no more additional output can be produced at a sustainable level/lowest possible average cost (where all factors of production are maximised).

Question 8

Economic efficiency

Answer 8

This occurs when we have allocative and productive efficiency at the same time.