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Functions of price Mechanism (1)

The document discusses the functions of the price mechanism in resource allocation, emphasizing the signalling and incentive functions that help balance supply and demand in markets. It illustrates these concepts using examples from the product market (masks) and the resource market (labor), showing how price changes influence production and consumption decisions. Additionally, it contrasts price rationing with non-price rationing, highlighting the importance of market mechanisms in distributing goods and services.

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Nadia Alrefaey
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© © All Rights Reserved
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Download as PDF, TXT or read online on Scribd
8 views

Functions of price Mechanism (1)

The document discusses the functions of the price mechanism in resource allocation, emphasizing the signalling and incentive functions that help balance supply and demand in markets. It illustrates these concepts using examples from the product market (masks) and the resource market (labor), showing how price changes influence production and consumption decisions. Additionally, it contrasts price rationing with non-price rationing, highlighting the importance of market mechanisms in distributing goods and services.

Uploaded by

Nadia Alrefaey
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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FUNCTIONS OF

PRICE MECHANISM
Learning Objectives

■ Functions of the Price Mechanism (AO2)


– Resource allocation
■ Signalling
■ Incentive
– Rationing
Resource Allocation

■ Resource allocation is basically tackling the basic economic questions


– Mainly WHAT and HOW to produce?
■ How does a society make a choice about where to be on its PPC?
– In a free market, or a market operating under competitive conditions,
the interaction between market demand and market supply determine
the equilibrium prices and quantities.
– At this equilibrium, the buying and selling choices are balanced.
– Firms produce only the goods/services consumers are willing and able
to buy and consumers buy only those that firms are willing and able to
supply.
– This market mechanism is working through prices.
How do Prices and Markets achieve
the task of Resource Allocation?
■ There are two Key Functions necessary for a market to allocate resources:
– Signalling Function
■ Price acts as signals since it communicates information to decision-makers.
– Incentive Function
■ Price motivate decision-makers to respond to information.
■ To further understand, what this means let us consider examples in two
different markets
– Product Market
– Resource Market
Functions of Price Mechanism
in Product Market
■ Case of Increasing Demand:
– Consider the market for masks during
those challenging times and consumers
want to remain healthy

■ This indicates there is a change in taste, and


demand on masks will increase shifting the
demand curve to the right from D1 to D2.

■ At P1, there is excess demand (QD2-Q1).


■ Price will begin to rise till there is no more ▪ This new higher price is also a signal and
shortage/excess demand. (P2)
incentive to consumers.
■ The new price signalled information to ▪ It signals that masks are now expensive, and
producers that there is a shortage in the
market, and created an incentive to produce is an incentive for them to buy less.
more since it became more profitable. ▪ Consumers will move along D2 – blue arrows
■ Producers will move along S1 – red arrows from (QD2, P1) to (Q2, P2)
from (Q1, P1) to (Q2, P2). ▪ The increase in prices resulted in
reallocation of resources, where more
resources were allocated to the production
of masks: Answering the question ‘WHAT’
Functions of Price Mechanism in
Resource Market
■ Case of Increasing Supply of Labour:
– Consider the market for labour during
peak times of immigrations.

■ This indicates there is an increase in supply,


and supply curve will increase shifting to the
right from S1 to S2.
■ At W1, there is excess supply/surplus
■ Wages will begin to fall till there is no more ▪ This new lower wage is also a signal and
surplus/excess supply. (W2( incentive to workers.
■ The new falling wage signalled information ▪ It signals that pays are now lower, and is
to producers that there is a surplus in the an incentive for them to offer less of their
labour market, and created an incentive to
hire and demand more services.
▪ Workers will move along S2 to (Q2, W2)
■ Movement along D –from (Q1, W1) to (Q2,
W2). ▪ The fall in wages resulted in reallocation
of labour resources, where more labour
resources were allocated to the
production : Answering the question
‘HOW’
PRICES AND It is the parceling out of goods and
services among consumers:
RATIONING All those who are willing and able to pay
will get and all those who are not will not
get it.
Price Rationing vs Non-Price
Rationing
■ Price Rationing is simply the market mechanism at work: Adam’s Smith the
Invisible Hand of the market (with no authority, buying and selling choices are
in balance)
■ Consider the case when price mechanism is not working due to price control
for example (Price Ceiling set by the government where equilibrium can be
restored)
– Higher prices cannot be implemented
– A non-price rationing system will come into play (example goods will be
parcelled out by first come, first served basis)
Formative Assessment

■ Consider the market for coffee, and suppose that the price for tea falls
– Draw the correct D-S diagram for coffee market with the effect of price
of tea on it (3 marks)
– Using diagram, explain the role of the price as a signal and as an
incentive for consumers and for firms in reallocating resources (6 marks)
.

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