1.2.7 Price mechanism, 1.2.8 Consumer & producer surplus

Definition of consumer surplus

The difference between the price a consumer is prepared to pay for a good/service & the market price paid

Definition of a producer surplus

Difference between the price the producers is prepared to supply the good/service at & the actual market price

What are the three functions of the price mechanism to allocate resources? (in order to restore market equilibrium)

1) Rationing

2) Incentive

3) Signalling

What is a rationing function

• Shift out in demand curve - causes an increase in price - rations consumer out to avoid excess demand - making it available only for those who can afford to purchase it

What is incentive function

• The higher price incentivises producers to allocate more factors of production to meet the new demand - extension along supply curve from Q1 to Q2

What is signalling

• Shifts out in demand curve signals to other producers that demand for the good is strong & the increase in price maximise profit - they should consider entering the market/switching some of their production from the old good to this new good

• As a result, new equilibrium + excess demand is eradicated

Evaluation for rationing

• Price increase not significant - many consumers still remain in the market - so rationing not as effective

Evaluation for signalling

• Shift in demand not significant - signalling not as effective