1. How markets and prices allocate resources

the 4 functions of prices

rationing, incentive, signaling and alocative function

what is the purpose of the functions of the price mechanism

to coordinate the descisions of buyers and sellers in a market economy to achieve an efficient allocation of resources

rationing function of the price mechanism

when rising prices result in consumers rationing their demand for a product distributing the finished product to the consumers who are willing to pay the most

incentive function of the price mechanism

when higher prices in a market create incentives for producers to supply more of a good or service because it indicates that more revenue can be made

signaling function of price mechanism

when prices change to provide information about the scarcity or surplus of goods and services to demonstrate where resources are needed

allocative function of the price mechanism

changing relative prices allocate scarce resources away from markets exhibiting excess supply into markets in which there is excess demand

eaxmple of the allocative function of prices

a high price in the electric car market would encourage firms to allocate all their FoP to the market away from petrol cars

how is the allocative function of prices different to the rationing function

allocative function affects producers and focuses on allocating factors of production between markets where there is more demand. whereas the incentive function focuses on increasing or reducing the supply inside a market

which functions effect producers

signaling, incentive

explain how the functions of the price mechanism would cause changes if there is an outward shift in demand

1) market allocates reasources at clearing price

2) demand shifts outwards

3) excess demand and supply shortages

4) excess demand places upward pressure on prices

5) higher prices signal excess demand and supply shortages

6) incentive function causes extention in supply

7) rationing function causes contraction in demand

8) allocate resources efficiently

advantages of the price mechanism

impersonal method of allocating resources

efficiency in resource allocation - resources allocated by consumer preferences (consumer sovereignty) and willingness to pay, leading to minimal wastage (depends on market structure)

promotes competition (depends on contestability)

encourages economic growth → – profit incentives drive investment, leading to higher productivity and growth (profit not guaranteed)

disadvantages of the price mechanism

missing markets (complete market failure) due to lack of incentives in particular markets eg street lights

equity arguments → regressive effect of price increases

doesn’t take into account externalities

monopolies → exploitation of consumers

the impersonal nature of the price mechanism

neoclassical economics believe that economic agents are self-interested. Therefore the market does not always allocate goods and services based on the greatest need and misses out social factors, which results in inequality or an insufficient provision of certain goods and services.

introducing the price mechanism into blood donation

changes the nature of the activity (altruistic motivations → monetary rewards)

raises questions of the activitiy’s ethics