Huw Thomas 12KE

Explain the functions of price in a market economy (10 marks)

A market economy is an economy in which decisions regarding investment, production and distribution are based on supply and demand, and prices of goods and services are determined in a free price system. The major defining characteristic of a market economy is that decisions regarding investments and the allocation of producer goods are accomplished primarily through markets and government intervention is minimal. Price has the most central role in a market economy and therefore it is the determinant demand, supply, and inflation. Secondly, price is central to the allocation of resources when demand and supply operates. Price has a huge influence on a market economy as it is known as a, rationing mechanism, in which rising prices signal to producers to supply more but more importantly indicate where factors should be employed and goods be rationed out between consumers. Therefore, agents should react automatically in a maximising manner and when the market works perfectly, this should produce an optimum outcome that satisfies all parties. Moreover, price affects both supply and demand for goods and services within a market economy. For example, as the price for a certain good or service increases, the demand for the product will decrease and vice versa when the price decreases. Likewise, price affects supply as an increase in the price of a good or service results in an increase in the supply of that certain product as producers look to maximise profits and revenues. However, a decrease in the price of a good or service will result in a decrease in the supply, as producers are not making as much from the sale of each unit sold. Conclusively, price has many functions, many of which are apparent in a market economy. Price has huge influences on both the supply and demand of goods and services and is also referred to many economists as a, rationing mechanism. However, price can also have negative influences on a market economy such as the running and illegal bootlegging of black markets.

Huw Thomas 12KE

Discuss whether the introduction of maximum prices by a government would solve the problem of scarcity (10 marks)
Scarcity is the fundamental economic problem of having seemingly unlimited human wants and needs in a world of limited resources. It states that society has insufficient productive resources to fulfil all human wants and needs. Moreover, A maximum price is a price ceiling set by the government where the price is not allowed to rise above this set level (although it is allowed to fall below). The reason for setting a maximum price is so that the prices of necessities dont rise too much in times of shortage. Such a situation is common in times of war and/or famine. Secondly, an effective maximum price would be set below the market equilibrium. Unless the government took additional measures, it would result in excess demand and a smaller quantity sold at a lower price. The situation can be shown in graph form in which the maximum price has caused a shortage, or excess demand equal to
Qd Qs:

Huw Thomas 12KE Moreover, the benefits that would be achieved through the implementation of maximum prices include a decrease in the prices of necessities and therefore, goods and services become more affordable to some consumers whereas others would now go without the good. However, there are detrimental effects that could occur through the use of maximum prices. These include product shortages and the creation of Black markets. These illegal activities include the selling of rationed goods illegally at very high prices to consumers who feel that they are not able to purchase enough legally. Moreover, the implementation of maximum prices reduces the supply of already scarce products. Conclusively, in theory, maximum prices are a good proposal but in practice they can make the issue of scarcity even worse. Another proposal to solve the issue of scarcity would be to offer subsidies to local manufacturers in the region.

Huw Thomas 12KE

Explain the difficulties of measuring inflation accurately (8 marks)

Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Inflation is measured by an index of consumer retail prices, otherwise known as a CPI. There are several problems with measuring inflation accurately and these will be explained in the latter of this essay. Initially, the Consumer Price Index is based only on a small fraction of the many goods and services that are available. If a person's buying habits differ substantially from the market basket on which the index is based, that person may experience a very different change in the cost of living than what the CPI shows. Secondly, another problem with measuring inflation accurately are the changes in the quality of goods. Changes in the quality of goods mean that price rises may not reflect inflation, but just the fact it is a different good. For example, computers have many more features than 10 years ago, so it is difficult to compare prices because they are effectively different goods. This is similar situation for many goods such as mobile phones and cars. Moreover, another difficulty that is apparent when measuring inflation is that the accuracy of the index can vary with the effectiveness of the data collection. Variables may not have been taken into account and the index may not be representative of the entire populations spending trends. For example, People have different inflation rates. Rising electricity and gas prices may affect old people more than young people. Therefore, old people could have a higher inflation rate than the national average. This is important if pensions are index linked because their cost of living may rise more than prices causing a decrease in living standards. Furthermore, measuring inflation accurately is difficult because the construction and coverage of the index may be poorly maintained. For example, the Family Expenditure Survey does not include everybody and excludes pensioners from the survey. Pensioners have different spending habits, including paying more on average for goods and services such as heating and public transport accounts. Young people will benefit more from falling prices of mobile phones and electronic goods. Therefore, the basket of goods may not be representative. Also, as it is updated once a year, it may soon become out-dated for changes in spending habits. Conclusively, there are several difficulties in measuring inflation accurately, including the changes in quality of goods and the poor construction and maintenance of an index such as the CPI.

Huw Thomas 12KE

Discuss whether inflation is necessarily harmful (12 marks)

Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. There are reasons to suggest that inflation is harmful and detrimental to the economy but many economists agree that there are possible benefits of inflation. Both sides of the debate will be discussed in the latter of this essay. Initially, economists agree that inflation is detrimental towards the economy and inflation is considered to be a problem when the inflation rate rises above 2%. The higher the inflation, the more serious the problem it is and in a modern economy, the Government are most concerned about the destabilising impact of inflation. One such problem with inflation is that it tends to discourage investment and long-term economic growth. This is because of the uncertainty and confusion that is more likely to occur during periods of high inflation. Moreover, Higher rates of inflation are disliked by business because it makes it more difficult to predict future costs. Therefore investment will be lower and many economists agree that countries with lower inflation rates generally have poorer economic growth. This is further supported and highlights the issues with inflation as higher rates of inflation may cause menu costs, which means firms have to change price lists quite often. Secondly, inflation is necessarily harmful to a countrys economy but it depends on inflation in other countries. For example, if inflation in Country X is higher than elsewhere, then Country Xs goods will become uncompetitive leading to a fall in demand for Country X exports. If there is a fall in demand for exports then there may be a deficit on the current account Balance of Payments. However this may be offset by a devaluation that is likely to occur. Moreover, if inflation is high there will be a devaluation of the exchange rate and this is something the government of Country X wishes to avoid as it creates uncertainty amongst business and lower purchasing power of Country Xs currency. Furthermore, inflation is detrimental as it leads to a reduction in the value of savings. Inflation leads to a fall in the value of money. This makes savers worse off and can lead to a redistribution of income in society. Often it is pensioners who lose out most from inflation. This is particularly a problem if inflation is high and interest rates low. However, there are reasons to suggest that inflation is beneficial to the economy. One such benefit of moderate inflation is that it enables the adjustment of prices and wages. It is argued a moderate rate of inflation makes it easier to adjust relative wages and prices. For example, it may be difficult to cut nominal wages as workers resent wage cut. But, if average prices are rising, it is easier to increase good

Huw Thomas 12KE workers wages more than unproductive workers. Moreover, inflation may be desirable as an incentive to producers and a stimulus to the economy. Inflation can boost growth. At times of very low inflation the economy may be stuck in a recession. Arguably targeting a higher rate of inflation can enable a boost to growth. Economists agree that in times of economic hardship, such as a prolonged recession, it is desirable to target higher levels of inflation. Moreover, deflation, otherwise known as a fall in prices is very harmful. For example, the Japanese economy has suffered lower growth because of deflation. When prices are falling people are reluctant to spend money because they are concerned that prices will be cheaper in the future, therefore, they keep delaying purchases. Therefore, inflation is usually advocated in preference to deflation, as the detrimental effects of deflation are much worse than those of inflation. Conclusively, there are both negative effects of inflation, which prove the statement that inflation can be harmful to the economy but there is also conflicting evidence that supports the idea that inflation can also be beneficial to the economy.