4.1.8.1 How markets & prices allocate resources

What’s the price mechanism?

• way in which prices are determined in a market economy.

How are prices determined in the price mechanism?

• through the interaction of buyers and sellers in the marketplace.

What are the 4 functions of price?

What does the signalling function of price mean?

• Prices provide information to buyers and sellers

What does the incentive function of price mean?

• Prices create incentives for people to alter their economic behaviour (SUPPLY mainly)

What’s the rationing function of price?

• Rising prices ration demand for goods/services (DEMAND) – only the more serious/wealthy consumers will continue to demand the good

What does the allocative function of price mean?

• Changing prices allocates scare resources away from markets exhibiting excess supply and into markets where there is excess demand.

Expand on the rationing function:

◎ Excess demand for a good or service will lead to a rise in the price of a good or service

◎ This is due to the scarcity of the product

◎ The price rise will lead to a reduction in demand

◎ The more scarce a product the higher the price

◎ This leads to a rationing of the product as its use is restricted

◎ There will be a movement along the demand curve showing a decrease in quantity demanded and a decrease in price

Draw a diagram to show the rationing function

• At price 𝑃 1 (below market equilibrium P) the quantity demanded is greater than the quantity supplied, thus creating excess demand.

• A price rise will ration the demand, a movement (up) along the demand curve

Expand on the incentive function:

◎ Higher prices act as a motivator for producers to increase the supply of a good or service

◎ This is due to greater contribution per unit i.e. the difference between selling price and variable cost

◎ As prices rise so do revenue and profit

◎ There will be a movement along the supply curve showing an increase in quantity supplied

Draw a diagram to show the incentive function

• At price 𝑃 1 (below market equilibrium P) the quantity demanded is greater than the quantity supplied, thus creating excess demand.

• A price rise will give an incentive to increase the supply, a movement (up) along the supply curve

Expand on the signalling function

◎ An increase in price will give an indication to producers that they should increase supply

◎ An increase in price will give an indication to consumers that they should reduce demand

◎ A decrease in price will give an indication to producers that they should decrease supply

◎ A decrease in price will give an indication to consumers that they should increase demand

◎ All of these signals will lead to shifts in the supply or demand curves

What are the types of efficiency?

• economic

• Productive

• Allocative

When does EE occur?

• when the maximum amount of products are produced at their minimum cost whilst maximising their benefit to society.

• occurs where we have allocative and productive efficiency at the same time

When does productive efficiency occur?

• occurs when an economy uses the minimum inputs to produce the maximum output at lowest cost

• occurs where no additional (or maximum) output can be produced from the factor inputs available at the lowest possible average or unit cost

When does allocative efficiency occur?

• occurs when society is producing goods to match the needs of consumers.

• occurs where consumer satisfaction is maximised in the production of goods and services

How can productive & allocative efficiency be illustrated?

• using a PPF

Show allocative efficiency on the PPF:

• Allocative efficiency takes into account the desires of consumers.

• If good Y is in greater demand than good X then production at point A will be more efficient than that of point B.

• Therefore, allocative efficiency can be found somewhere on the PPF but at what point depends upon consumer preference.