8.1

• Functions of price

  1. Signalling function
  2. Incentive function
  3. Rationing function
  4. Allocative function
• signalling function of prices definition

  prices provide information to buyers and sellers on what to buy
• incentive function of prices definition

  prices create incentives for people to alter their economic behaviour e.g a higher price creates an incentive for firms to supply more of a good or service
• rationing function of prices definition

  when there are scarce resources, rising prices ration demand for a product
• allocative function of prices definition

  Changing relative prices allocate scarce resources away from markets exhibiting excess supply and into markets in which there is excess demand
• example of rationing function of price

  plane tickets prices rising as spaces running out
• incentive function of prices example

  high price would encourage firms to supply more to the market to profit maximise
• signalling function of prices example

  high price signals firms to enter market. however, encourages consumers to reduce demand and leave market
• allocative function of price example

  If high price for bread, firms will produce more bread
• what does the price mechanism do?

  determine the market price and allocate resources in a free market economy
• what is ’Adam Smith’s invisible hand of the market’ ?

  Idea that the pursuit of individual self-interest in the market economy leads to outcomes which are in the common good or public interest - as long as market is free and competitive
• in highly competitive firms, both firms and consumers will passively accept market prices set by interaction of supply and demand
• in pure market economy, prices and markets allocate scarce resources between competing uses
• in mixed economies, interaction of markets and prices plays role in allocating resources
• Producers will switch productive resources into markets which maximise their return. All this takes place through the invisible hand e.g making electric cars gives bigger profit than petrol cars so firms moves more workers there
• price mechanism advantages

  • promotes consumer sovereignty (consumers control what gets produced) - consumer holds most power in market
  • Productively efficient allocation of resources - avoid waste
  • Prices signal shortages or surpluses
  • provides incentives for producers and consumer to change their behaviour
  • Allocatively efficient outcome
  • System works automatically - no need for government intervention
  • flexibility - economy can quickly respond to changes in consumer preferences, technology or resource availability
• Price mechanism disadvantages

  • inequality - More money=more influence, basic needs may be unaffordable for poor
  • Public goods not provided
  • Market failure - overproduction of harmful goods, underproduction of beneficial ones and negative externalities
  • Imperfect information - may not make best decisions
  • Short-term focus - firms may focus on quick profits not long-term e.g sustainability
  • value neutral - no moral or ethical judgments, only responds to demand and supply
• what do free market economics believe?

  • government interference in markets can lead to market failure
  • price mechanism should be extended into parts of the economy where state provision dominates
• what to interventionist economists believe?

  markets often perform badly, and government intervention can improve the efficiency of markets or make them work better for consumers
• in imperfectly competitive markets and monopoly, the operation of price mechanism leads to an outcome in which firms exploit their producer sovereignty - producer holds more power
• the price mechanism is ‘value neutral,’ what does that mean?

  has no regard for equality and the fairness or otherwise allocation of buying power between different income groups