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Market System
Resources are allocated according to the market forces of demand and supply (free of government intervention).
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.
Perfect Competition (efficient allocation feature)
Many buyers and sellers
Rational Behaviour (efficient allocation feature)
Consumers assumed to maximise utility
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.
Private Ownership of Property (efficient allocation feature)
Individuals have the right to own
Signalling Function of Prices
Prices communicate information to decision-makers
Rationing Function of Prices
Prices ration goods/resources to consumers/producers willing and able to pay. Shortage -> P ↑ -> discourages consumption
Incentive Function of Prices
Motivates behaviour change. Higher P -> existing producers ↑ output (more revenue/profits). Lower P -> consumers ↑ Qd (maximise utility).
What and How Much to Produce
Firms produce goods consumers are willing & able to buy; consumers buy goods producers are willing & able to supply.
How to Produce
Firms use best resource combination to produce given output at lowest possible average cost.
For Whom to Produce
Determined by consumers' "dollar votes"; those with more money can consume more goods.
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."
Equilibrium Price and Output
Occurs at the price where quantity demanded by consumers equals quantity supplied by producers (Qd = Qs).
Market Clearing Price
Another term for equilibrium price.
Disequilibrium
Occurs at any price other than equilibrium where Qd and Qs are not equal (shortage or surplus).
Shortage
Qd > Qs -> upward pressure on price (consumers outbid each other).
Surplus
Qs > Qd -> downward pressure on price (producers lower price to sell excess stock).