Booklet 4 - price determination + price mechanism

Consumer preferences - PASTA ( explain the diagram of how a change in consumer preferences changes the market equilibrium )

• the initial equilibrium shows a price P0 and quantity traded of dried pasta Q)

• the likely change is an increase in demand as a change in peoples preferance shift the demand curve to the rihgt from D1 to D2

• the market now adjusts to a new equilibrium with a new price of P1 and a new quantity traded of Q1 - if price stays at P0 there will be a shortage and excess demand

• In case of both price and quantity traded increases due to an increase of consumers wishing to buy more pasta due to health benefits, market will cause price to rise from P0 to P1, which will lead to an extention in supply as more producers are willing to supply more pasta at a higher price and a contraction in demand, thus eliminating excess demand

change in the price of a substitute - pasta

• shift in demand from D1 to D3

• new equillibrium is P2 Q2

• market forces will cause prices to fall from P1 to P"2 which will lead to a contraction in supply as the producers are less willing to supply, reducing excess suppply

• extension in demand

a firms accountant brings a new, fast computer - which have effect on the firms costs

• shift in supply from s1 to s2

• the new equilibrium point will be at p2 and q2

• due to market forces it will cause price to decrease from p1 to p2, which will lead to an extention in demand, and a contraction in supply eliminating excess supply

what are the function of the price mechanism

• signalling

• incentive

• rationing

explain the rationing function of the price mechanism (ARSI)

• one function is to allocate and ration scarce recourses

• as supply is scare - prices will high

• limited supply will be rationed to those consumers who are willing and able to pay the higher price

explain the incentive function of the price mechanism (ARSI)

• incentives motivate the producer or consumer to follow a course to change behaviour

• Higher prices incentivise producers to supply more due to higher revenue and profit margains

• this leads to an extension in supply and a contraction in demand, balancing the market at market equilibrium

explain the signalling function of the price mechanism (ARSI)

• rising prices give a signal to consumers to reduce demand

• this signals producers to adjust output levels

• reaching market equillibrium