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    Price Mechanism

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    Ryan Thomas
    The price mechanism allocates resources in a free market system. Price acts as a signal to producers - if demand increases, price rises which incentivizes producers to increase supply for greater profits. If demand decreases, price falls which moves resources away from that product. One advantage is that it achieves technical efficiency as producers seek to minimize costs. A second advantage is that it leads to allocative efficiency as resources flow to where they yield highest profits based on consumer demand. However, it does not always operate smoothly. One disadvantage is that unequal income distribution can lead to unsatisfactory allocation as the poor have limited access. A second disadvantage is that it fails to account for external costs and benefits of production and consumption.

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    Price Mechanism

    Uploaded by

    Ryan Thomas
    178 views10 pages
    The price mechanism allocates resources in a free market system. Price acts as a signal to producers - if demand increases, price rises which incentivizes producers to increase supply for greater profits. If demand decreases, price falls which moves resources away from that product. One advantage is that it achieves technical efficiency as producers seek to minimize costs. A second advantage is that it leads to allocative efficiency as resources flow to where they yield highest profits based on consumer demand. However, it does not always operate smoothly. One disadvantage is that unequal income distribution can lead to unsatisfactory allocation as the poor have limited access. A second disadvantage is that it fails to account for external costs and benefits of production and consumption.

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    just short note

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    The price mechanism allocates resources in a free market system. Price acts as a signal to producers - if demand increases, price rises which incentivizes producers to increase supply for greater profits. If demand decreases, price falls which moves resources away from that product. One advantage is that it achieves technical efficiency as producers seek to minimize costs. A second advantage is that it leads to allocative efficiency as resources flow to where they yield highest profits based on consumer demand. However, it does not always operate smoothly. One disadvantage is that unequal income distribution can lead to unsatisfactory allocation as the poor have limited access. A second disadvantage is that it fails to account for external costs and benefits of production and consumption.

    Copyright:

    © All Rights Reserved
    Download as TXT, PDF, TXT or read online from Scribd
    Download as txt, pdf, or txt
    178 views10 pages

    Price Mechanism

    Uploaded by

    Ryan Thomas
    The price mechanism allocates resources in a free market system. Price acts as a signal to producers - if demand increases, price rises which incentivizes producers to increase supply for greater profits. If demand decreases, price falls which moves resources away from that product. One advantage is that it achieves technical efficiency as producers seek to minimize costs. A second advantage is that it leads to allocative efficiency as resources flow to where they yield highest profits based on consumer demand. However, it does not always operate smoothly. One disadvantage is that unequal income distribution can lead to unsatisfactory allocation as the poor have limited access. A second disadvantage is that it fails to account for external costs and benefits of production and consumption.

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    © All Rights Reserved
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    Explain how the price mechanism allocates resources and describe some of

    its advantages and disadvantages (12)




    Under a free market economic system, resources are allocated according to the
    price mechanism. Consumer wants are infinite and resources are scarce,
    therefore these scarce resources need to be allocated between competing uses. On
    e
    way is this done is through price.

    Price acts as a signal to producers. In a market economy, changes in demand
    eventually bring about changes in supply. If consumer demand for a product
    increases, the resultant shortage will cause the price to increase. As producers
    of
    the product can now make more profit on this good they will switch more
    resources into the production of the good (as they are profit maximisers),
    therefore the increase in demand leads to increases in supply and vice versa. If

    consumer demand for a product falls, the resultant glut/surplus will cause its
    price to fall resulting in a fall in the profit made on the good. Resources are
    then
    moved out of the production of that particular product and used to produce those

    products that are now relatively more profitable.

    One of the most cited advantages of the price mechanism is that it best achieves

    an economically efficient allocation of resources. Technical efficiency is
    achieved as producers produce at minimum unit cost, in other words, when the
    fewest necessary resources are used to produce each product. This is because
    firms are profit maximising and given the degree of competition in a free
    market they will want to produce at a point where costs are minimized. There is
    a greater incentive for firms to cut costs, increase productivity and develop ne
    w
    products because of the chance of extra profit. In the long run (because of the
    high
    degree of competition), firms are producing at the lowest point in the average c
    ost
    curve. If all firms operated under these conditions it would follow that there
    would be an optimum allocation of resources and every commodity would be
    produced at a minimum cost per unit.

    Markets also tend towards allocative efficiency. Customers are able to cast thei
    r
    spending votes in the market. This determines what is produced. Prices signal
    the value of individual resources and resources flow to where they yield the
    highest profit. In other words, the invisible hand of the market would allocate
    resources to everyones advantage. For example, if consumers want to buy more
    I-pods and fewer CDs, then I-pod firms will expand production, whilst
    manufacturers of CDs will cut production. All firms would be producing to
    consumers demand curves i.e. goods which people desire. Furthermore, the market
    is flexible so that changes in demand quickly bring about changes in supply so
    surpluses / shortages do not last.






    Define the price
    mechanism fully


















    Describe the first
    advantage of the
    price mechanism














    Describe the
    second
    advantage of the
    price mechanism
    One of the disadvantages of the having the price mechanism allocating resources
    is that it does not always operate smoothly. In a market economy an
    individuals ability to consume goods & services depends upon his/her income.
    An unequal distribution of income and wealth may result in an unsatisfactory
    allocation of resources. The relatively poor do not have access to the range of
    goods and service consumed by average citizens. High inequality may also
    lead to social exclusion and encourage crime with negative consequences for all.

    The market system will not respond to the wants of those with insufficient
    purchasing power because what matters in a market based system is your
    effective demand for goods and services. Therefore, government may intervene
    by providing merit goods such as education and healthcare, and benefits such as
    Job Seekers Allowance, child benefit, etc. The finance comes out of taxation,
    much of which bears more heavily on the rich.

    The price mechanism also fails to take into account market failure. In a free
    market, the costs which a firm takes into account when making decisions are
    those which it has to pay, i.e. private costs. Similarly a consumer when making
    decisions about what and how much to buy only considers private benefit, i.e. th
    e
    benefit (utility) which he receives. However, the production and consumption of
    a product may have spillover effects on people not directly involved in its
    production or consumption. These spillover effects are called external costs and

    benefits.
























    Describe the first
    disadvantage of
    the price
    mechanism















    Describe the
    second
    disadvantage of
    the price
    mechanism

    Explain the difference between scarcity and a shortage (8)

    Scarcity is the basic economic problem which arises because human wants which
    are unlimited, exceed the goods and services which can be produced at any one
    time because of finite resources.

    Individuals, businesses and governments always want more. Their wants are
    insatiable because goods eventually wear out and need to be replaced i.e.
    electronic appliances. New or improved products become available i.e. mobile
    phones. Some people argue that the desire to consume is innate and it is human
    nature that once one want is satisfied, they want more. Others argue that
    advertising plays a powerful role in creating new wants i.e. downloadable ring
    tones like Crazy Frog. It is important to note that the concept of unlimited
    wants is not only confined to goods and services, but other items such as a bett
    er
    environment, more leisure time, better relationships, etc.

    Resources are limited in relation to the demands placed on them. For example, th
    e
    total surface area in the world is fixed, and many natural resources are non-
    renewable like oil. Indeed, over-fishing in Scotland led to a ban on Cod fishing

    in the North Sea. There are limited supply of workers and risk takers. Indeed,
    this point was highlighted on the front cover of the Economist in October 2006
    with articles on the shortage of talent. With regards to capital, there is a limit

    to how much investment a firm can make.

    Shortage arises when the demand for a product at a particular price cannot be
    met i.e. when demand exceeds supply the quantity which consumers want and
    are able to buy is not being produced. In a market economy, shortages usually
    dont last long and will be cured by a rise in price and/or an increase in supply.

    Demand is a want backed up by the ability to pay and is therefore limited by
    income. Scarcity is different because we talk about unlimited wants (not
    demand) and how they are never fully satisfied. If there was no shortage there
    would still be scarcity because of all those consumers who want the product but
    cannot afford to pay.











    Define scarcity





    State why wants
    are unlimited
    provide
    examples.









    State why
    resources are
    limited provide
    examples.







    Define shortage
    and state the
    difference
    between it and
    scarcity.

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