Price Mechanism

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Economics Revision Focus: 2004

AS Economics
Functions of the Price Mechanism

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Functions of the Price Mechanism

Revision Focus on the Functions of the Price Mechanism
AS Syllabus Requirements: How Markets and Prices Allocate Resources Candidates should understand the rationing, incentive and signalling functions of prices in allocating resources and co-ordinating the decisions of buyers and sellers in a market economy. The invisible hand – the workings of the price mechanism The price mechanism is simply the means by which the millions of decisions taken each day by consumers and businesses interact to determine the allocation of scarce resources between competing uses. This is the essence of economics! The price mechanism plays three important functions in any market-based economy The signalling function Prices have a signalling function. Prices adjust to demonstrate where resources are required, and where they are not. Prices rise and fall to reflect scarcities and surpluses. If market prices are rising because of stronger demand from consumers, this is a signal to suppliers to expand output to meet the higher demand. Consider the left hand diagram below. The demand for computer games increases. Producers stand to earn higher revenues and profits from selling more games at a higher average price. So an outward shift of demand leads to an expansion along the market supply curve (ceteris paribus)

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Functions of the Price Mechanism

Higher demand signals to producers to step up production – if they are driven by the profit motive

An increase in supply leads to lower market prices – a signal to consumers that their real income has increased – they can afford to buy more

Price of Computer Games

Price of Digital Cameras S1 S1 S2

P2 P1

P1

D2 D1

P2

D2

Q1

Q2 Quantity

Q1

Q2 Quantity

In the second example on the right, an increase in supply causes a fall in the relative prices of digital cameras and prompts an expansion along the market demand curve The transmission of preferences Through the signalling function, consumers are able through their expression of preferences to send information to producers about the changing nature of our needs and wants. When demand is strong, higher market prices act as an incentive to raise output (production) because the supplier stands to make a higher profit. When demand is weak market supply contracts. The rationing function Prices serve to ration scarce resources in situations when demand in a market outstrips supply. When there is a shortage of a product, the price is bid up – leaving only those with sufficient willingness and ability to buy with the effective demand necessary to purchase the product. Be it the demand for cup final tickets or the demand for a rare antique the market price acts a rationing device to equate demand with supply.

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Functions of the Price Mechanism

The growing popularity of auctions as a means of allocating resources is worth considering as a means of allocating resources and clearing a market. Adam Smith and the Invisible Hand The 18th Century economist Adam Smith – one of the founding fathers of modern economics, described how the invisible or hidden hand of the market operated in a competitive market through the pursuit of self-interest to allocate resources in...
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