PM P1: Market Economy

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18 Terms

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Market System

Resources are allocated according to the market forces of demand and supply (free of government intervention).

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Price Mechanism

Operates in market economies where changes in prices cause resources to move in or out of industries; referred to as the "invisible hand" by Adam Smith.

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Perfect Competition (efficient allocation feature)

Many buyers and sellers

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Rational Behaviour (efficient allocation feature)

Consumers assumed to maximise utility

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Freedom of Choice and Enterprise (efficient allocation feature)

Consumers are free to decide what to buy with their incomes (consumer sovereignty); firms are free to choose what to sell and what production methods to use.

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Private Ownership of Property (efficient allocation feature)

Individuals have the right to own

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Signalling Function of Prices

Prices communicate information to decision-makers

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Rationing Function of Prices

Prices ration goods/resources to consumers/producers willing and able to pay. Shortage -> P ↑ -> discourages consumption

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Incentive Function of Prices

Motivates behaviour change. Higher P -> existing producers ↑ output (more revenue/profits). Lower P -> consumers ↑ Qd (maximise utility).

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What and How Much to Produce

Firms produce goods consumers are willing & able to buy; consumers buy goods producers are willing & able to supply.

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How to Produce

Firms use best resource combination to produce given output at lowest possible average cost.

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For Whom to Produce

Determined by consumers' "dollar votes"; those with more money can consume more goods.

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Market Equilibrium

"A situation in which buyers and sellers are on aggregate satisfied with the current combination of price and quantity of a good bought or sold and there is no inherent tendency for price to change unless the equilibrium is disturbed."

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Equilibrium Price and Output

Occurs at the price where quantity demanded by consumers equals quantity supplied by producers (Qd = Qs).

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Market Clearing Price

Another term for equilibrium price.

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Disequilibrium

Occurs at any price other than equilibrium where Qd and Qs are not equal (shortage or surplus).

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Shortage

Qd > Qs -> upward pressure on price (consumers outbid each other).

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Surplus

Qs > Qd -> downward pressure on price (producers lower price to sell excess stock).