4.1.8.1 - How Markets and Prices Allocate Resources (Market & Price Mechanism)

Price Mechanism =

The interaction of supply and demand in a market economy that allocates scarce resources amongst competing needs and wants (to resolve the basic economic problem of unlimited wants but scarce resources)

4 Functions of the Price Mechanism

- Rationing

- Incentive

- Signalling

- Allocative

RATIONING Function of Prices

Increasing prices rations demand for a product. Helps establish equilibrium.

• When there is a shortage of a good, the price will rise to deter consumers who cannot afford it from buying it.

• When there is a surplus of a good, the price will fall to allow more consumers to afford it.

INCENTIVE Function of Prices

Prices create incentives for people to alter their economic behaviour.

• Encourages firms to increase or decrease output to increase profits.

• For example, a higher price creates an incentive for firms to supply more of a good/service to increase profits.

SIGNALLING Function of Prices

Prices provide information to buyers and sellers about where resources are wanted (markets with increasing prices) and where they are not (markets with decreasing prices).

• For example, a sudden rise in a competitor's prices might indicate a rise in demand for similar products.

• High prices signal to a producer to produce more of that good/service, and would signal to other producers to enter the market

ALLOCATIVE Function of Prices

Changing relative prices allocate scarce resources away from markets exhibiting excess supply and into markets in which there is excess demand --> allocative efficiency.

• Prices are useful because they allocate resources to different markets based on market conditions. When prices are set above equilibrium in markets and there is therefore excess supply, resources are allocated away from these markets and towards markets with excess demand. This pushes prices towards equilibrium in both markets.

Advantages of Price Mechanism

• More efficient allocation of resources - resources are allocated to their most valued use for production and consumption (where they are most needed)

• Greater productive efficiency - firms need to have efficient production to maximise their output from their given resources and max profits, Consumers have to be efficient in choices to max their utility from limited income

• Freedom of choice - Consumers choose goods and services based on tastes, preferences, and income that producers then allocate resources towards the needs & wants of consumers.

• Lower Prices & Higher Quality - Competition of firms keeps down prices and drives up the quality of goods and services & also leads to innovation to retain customers in order to max profits

Disadvantages of Price Mechanism

• Inequality - People with higher income have more buying power (effective demand), whilst lower income people may end up deprived of necessities.

• Market Failure of Externalities - Over-provision of goods that have negative externalities, Under-provision of goods that have positive externalities

• Market Failure of Missing Markets - Under-provision of public goods (gov intervention therefore necessary)

• Information Failure - If left to free market, consumers may be exploited by assymetric info --> market failure

• The use of the price mechanism in some markets could be undesirable or distort incentives

  • e.g. Using price mechanism for markets for life saving treatments such as blood or organ donations would incentivise high prices and create inequalities in access