HOW MARKETS AND PRICES ALLOCATE RESOURCES: AQA Economics Specification Topic 4.1

Topic 4.1 - Individuals, firms, markets and market failure

Snapshot of the AQA syllabus topic area we’ll be covering in this post.

HOW MARKETS AND PRICES ALLOCATE RESOURCES: The market mechanism, market failure and government intervention in markets

AQA students must understand the following content [taken from the syllabus]

• The rationing, incentive and signalling functions of prices in allocating resources and coordinating the decisions of buyers and sellers in a market economy.

• The advantages and disadvantages of the price mechanism and of extending its use into new areas of activity.

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ESSENTIAL INFORMATION

[NOTE: supplementary knowledge, supporting diagrams and questions at the end]

INTRODUCTION TO THE PRICE MECHANISM

In a market economy, the interaction of buyers and sellers through the pricing mechanism largely determines how resources are allocated. Rationing, incentives, and signalling are the three main purposes of this mechanism. It organises the choices made by buyers and sellers, has an impact on manufacturing decisions, and affects how goods and services are distributed.

However, it is crucial to take into account the price mechanism's benefits and drawbacks as well as any possible consequences of expanding its application to new fields of activity.

1. Rationing Function:

The price mechanism decides how limited resources are distributed among competing uses, serving as a rationing tool.

Prices increase when supply is insufficient to meet demand, motivating consumers to make cutbacks and direct resources to their most important purposes. For instance, if a certain product is in short supply, its price will rise, causing consumers to hesitate and therefore reducing excessive demand.

2. Incentive Function:

Prices offer both buyers and sellers financial incentives. Suppliers are encouraged to expand production as higher pricing allows them to make more money. Lower prices, on the other hand, discourage more production because a seller’s profits are reduced.

Lower market prices encourage consumers to buy more, whereas higher market prices motivate people to consume less or look for alternatives.

Prices influence both buyers' and sellers' behaviour in this way, encouraging effective resource allocation.

3. Signaling Function:

Prices provide important information regarding the relative availability and demand for goods and services.

Price increases are a sign that either supply is constrained or demand is strong. Participants in the market are influenced by this knowledge to modify their behaviour.

For instance, price increases might entice new enterprises to the market and boost supply, which would stabilise prices.

ADVANTAGES OF THE PRICE MECHANISM

• Efficiency

  • Because the price mechanism guides resources towards their most valuable uses based on consumer preferences and market demand, it allows for efficient resource allocation.

• Flexibility

  • Prices are quick to respond to shifts in supply and demand, enabling prompt adjustments to resource allocation.

• Decentralised Decision Making:

  • Decentralised economic coordination results from the price mechanism, which empowers millions of buyers and sellers to act independently and in their own self-interest.

DISADVANTAGES OF THE PRICE MECHANISM

• Inequality

  • Inequality can be the result of the price mechanism, because those with greater purchasing power can afford to bid up prices and purchase more goods and services.

• Externalities

  • The costs and benefits placed on third parties (externalities) that are not accounted for in prices may go unaccounted for. For instance, market prices might not fully take into account the pollution brought on by industrial activity.

• Public goods

  • Because people may underconsume or free-ride on public goods, the pricing mechanism has trouble allocating resources when goods are non-excludable and non-rivalrous. This can lead to complete market failure, meaning an unwillingness of entrepreneurs to sell these sorts of products.

EXPANDING THE PRICE MECHANISM INTO DIFFERENT MARKETS

When considering the extension of the price mechanism into new areas of activity, it is essential to assess the potential advantages and disadvantages it may bring.

Advantages:

• Resource allocation: the price mechanism typically allows for an efficient allocation of resources, leading to enhanced productivity and growth

• Innovation: the market mechanism allows for competition and innovation - businesses try and offer the best possible products and services at competitive prices

• Individual freedom: the price mechanism allows individuals to make their own choices, leading to an improved level of welfare within society

Disadvantages:

• Social implications: certain markets, like education and healthcare, do not always mix well with the price mechanism. This is because wealthier individuals have an advantage when it comes to these crucial services that enhance opportunities for citizens

• Ethical concerns: there are ethical arguments involved in certain markets, which the price mechanism won’t take account of. Example industries could be organ trading or ivory trading which is derived from wild animals

INFLUENCE OF ECONOMIC INCENTIVES

What is produced, how goods and services are produced, and for whom they are produced are all influenced by economic incentives.

The profit motive drives producers to satisfy consumer demand whilst simultaneously maximising their profits.

Consumers, on the other hand, make decisions taking into account the price, the potential benefits a product will offer them, and their individual budget constraints.

IMPERSONAL NATURE OF THE PRICE MECHANISM

The price mechanism can be very cutthroat and impersonal. Buyers and sellers operating in the market are motivated by self-interest, rather than interpersonal connections. The market focuses purely on the exchange of goods and services and not necessarily the people involved. The market does not always allocate goods and services based on the greatest need, and this can be a failure of such a mechanism. Critics point out that the price mechanism often misses out social factors, which results in inequality or an insufficient provision of certain goods and services.

A good example of this could be the Covid-19 vaccine programme. Were individuals with the greatest need the first to be offered vaccines around the globe?

IMPACT OF THE NATURE OF HUMAN ACTIVITY

The introduction of markets and the price system can have a significant impact on the nature of some human endeavours.

For example, the creation of a market for blood donations may change the altruistic motivations behind blood donation and replace them with monetary rewards. The potential monetisation of some parts of human life as well as questions about the activity's ethics and integrity may be raised by this transition.

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SUPPORTING DIAGRAMS

diagram showing the incentive and rationing functions of the price mechanism - an increase in demand for a product triggers both the incentive and rationing functions - the incentive function is triggered because producers wish to use this opportunity to make more profit - this means they will raise prices and produce more products - the rationing function is triggered because of the existence of limited resources - more consumers competing for a finite amount of resources leads to the price to rise, in order to wane off demand

diagram showing the signalling function at work - higher prices in the market act as a signal to new firms - higher prices often signal that a market is doing well and there is alot of economic activity there - this information is then processed by new firms/consumers which results in a reaction

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SUPPORTING QUESTIONS

Question: The demand for smartphones is expected to grow in the next year. Explain how the price mechanism would facilitate the transition between today’s equilibrium and next year’s equilibrium. Utilise the functions of the price mechanism in your explanation.

Answer:

When the demand for a product increases, the price mechanism plays a vital role in facilitating the transition from the old equilibrium to the new equilibrium.

There are 3 functions of the price mechanism: rationing, incentive and signalling. Rationing refers to how the price increases in markets to wane off excess demand for limited resources. Incentive refers to how economic agents try to maximise their welfare by pursuing goals - in particular, how firms are incentivised to produce more at higher prices. The signalling function refers to how the price mechanism offers information to people within the economy - for example, the price mechanism prompts suppliers and consumers to change their behaviour if the price of a product goes up or down. Rising prices would signal to producers to start allocating more resources towards that market - to consumers it might signal that a particular product is very sought after or scarce.

The transition between the old and new equilibrium points would work as follows:

Firstly, producers would notice an excess level of demand in the market because they’d be unable to keep up their supply to match the quantity that people want to buy. This means producers are incentivised to raise prices and production levels in the pursuit of more profit. On the consumer side, rising prices would start incentivising them to reduce their demand for the product.

In summary, the price mechanism facilitates the transition from the old equilibrium to the new equilibrium when the demand for a product increases. Through its rationing function, it adjusts prices to manage excess demand and reduce shortages. The incentive function encourages producers to increase supply in response to the higher prices, while the signaling function guides both producers and consumers in their decision-making processes.

The interrelationship between these functions helps achieve a new equilibrium position, where demand = supply at a higher prices than before, thereby accommodating the increased demand for the product.