Price Mechanism Price Mechanism D & S issues Mrs Gordon's notes

Aims of the syllabus Understand the rationing, incentive and signalling functions of the price mechanism for allocating scarce resources. Review & development of consumer & producer surplus.

Role of markets So far we have focused on consumer markets, however, from one of our first lessons we looked at the range of markets. Your exam board tend to expect you to raise your horizons to more sophisticated markets: Agricultural markets Housing markets Labour markets Currency markets Commodity markets

Adam Smith - The moral philosopher and political economist (1723-1790) Price Mechanism Adam Smith - The moral philosopher and political economist (1723-1790) He provided a strong argument for a free market in which the invisible hand of the market would allocate resources to everyone’s advantage. He identified THREE agents within a market system: Consumers Producers Owners of FoPs Mrs Gordon's notes

Price Mechanism Consumers In a free market Mrs Gordon's notes

Consumers Consumers are free to spend their money as they wish (in a free market) They demand a wide range of goods to satisfy their needs & wants Utility, welfare & satisfaction play a role here. If a consumer really wants a product, then they are free to pay above the market price, i.e. consumer surplus.

Consumer Surplus…. Consumer surplus measures the welfare that consumers derive from their consumption of goods and services, or the benefits they derive from the exchange of goods.  Consumer surplus is the difference between what consumers are willing to pay for a good or service (indicated by the position of the demand curve) and what they actually pay (the market price). 

Price Mechanism Producers In a free market Mrs Gordon's notes

Producers – in a free market They are the ‘slaves’ of the consumers! Motivated by high profits Aim to maximise difference between revenues & costs High revenues – producing what the consumers want Low costs – minimise costs so that they can either sell at a lower price or gain high profit margins!

Producer surplus It is the difference between what producers are willing and able to supply a good for and the price they actually receive. The level of producer surplus is shown by the area above the supply curve and below the market price

Price Mechanism Owners of FoP’s In a free market Mrs Gordon's notes

All want the highest return possible on their assets Owners of FoP’s All want the highest return possible on their assets Capital Labour Enterprise Land

Function of Prices… In a free market Price Mechanism Mrs Gordon's notes

The 3 Functions of Price Rationing Signalling Incentive

Rationing If there are scarce resources, then they need to be rationed between the consumers infinite wants. Draw an elastic Demand curve Draw an inelastic Supply curve What would happen under the market mechanism if there was a fall in supply? What has happened along the Demand curve? How does this link to income effect & substitution effect?

Signalling The price of a good sends clear signals to both consumers and producers If the price is set below the market equilibrium…. Draw this on a D & S diagram. What happens to D & S? WHY does this happen?

Incentive Low price tag encourages consumers to buy more – it increases your utility or amount of satisfaction. Higher prices discourage consumers from buying – due to income effect. Low prices discourage production A long fall in prices will drive some firms out of the marker. High prices encourage firms to supply more, take on more workers & invest in new technology.

Exceptions to the laws of demand When an increase in price acts encourages demand!

Price mechanism in action – gold! The high price of gold is giving a clear signal to a mining company in the Highlands of Scotland that it should start production from a gold mine that was first drilled 20 years ago, but has never been commercially worked because the price of gold did not provide enough incentive to the producers. However with the price of gold now at $1100 per ounce, mining operations could become profitable. Scotgold owns the Coronish mine near Tyndrum, a small village which is en route to Glen Coe, Fort William and Skye. Cononish is expected to start producing 200kg of gold a year at the mine site when full-scale mining begins in 2011 – enough to produce 30,000 wedding rings a year – and another 500kg each year by sending rocks for processing elsewhere.

AS Multi choice practice Complete your answers on BACK of sheet. Choose option & explain (define, formula / calculate, explain)

AS Multi choice practice Complete your answers on BACK of sheet. Choose option & explain (define, formula / calculate, explain)

Price Mechanism 1. Mrs Gordon's notes

Answer:B (1) Explanation of how prices ration scarce goods – interaction of supply and demand (2) Supply and demand diagram to show equilibrium price (1) plus a further mark (1) for showing a change in equilibrium price (2) Correct identification of other features of free market economy, e.g., private ownership of resources - up to 2 marks (2) Also allow credit for: Definition of price mechanism (1) Definition of scarcity (1)

2.

Answer:A (1) Definition of income elasticity of demand (2) Correct numerical calculation (2) Potatoes are an inferior good (1) A rise in incomes will cause a fall in demand (1)

3.

Answer:C (1) Define consumer surplus (2 marks) or description of the area between demand curve and price (1 mark). Maximum of 2 marks can be awarded here. Diagram or written explanation that consumer surplus falls when the supply curve shifts to the left – caused by a rise in the costs of production (2 marks).

4.

Answer: B (1) Explanation that increase in demand for rugby balls causes publicity & participation generates a shift in demand from D1 to D2 (1 mark). Explanation that fall in costs will result in shift of the supply curve from S1 to S2 (1 mark) With signals to generate more profit (1 mark). Annotation of diagram (1 mark)