How markets and prices allocate resources

• What does the price mechanism determine in a market economy?

  The market price
• Who referred to the price mechanism as ‘the invisible hand of the market’?

  Adam Smith
• How are resources allocated in a free market economy?

  Through the price mechanism
• What economic problem does the price mechanism solve?

  The problem of scarce resources
• How does the price mechanism respond to a shortage of resources?

  It moves resources to where they are demanded
• What happens to resources in the case of a surplus according to the price mechanism?


  Resources are removed from where there is a surplus
• What are the three main functions of the price mechanism in resource allocation?

  • Rationing
  • Incentive
  • Signalling
• What occurs to prices when there are scarce resources and excess demand?

  Prices increase
• How does an increase in price affect consumer behavior regarding scarce resources?

  It discourages demand
• What is an example of rationing in the context of the price mechanism?


  Plane tickets rising in price as seats are sold
• What does the incentive function of the price mechanism encourage?

  A change in behavior of a consumer or producer
• How would a high price affect firms in the market?


  It would encourage firms to supply more to the market
• What role does price play as a signal in the market?


  It shows where resources are needed
• What happens when a high price signals firms to enter the market?

  It encourages consumers to reduce demand
• How does the price mechanism resolve the basic economic problem in a market economy?

  By allocating resources based on supply and demand