The Price Mechanism and Resource Allocation - Sancta Maria College

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					   The Functions of Price and
     Resource Allocation

    This presentation considers the rationing and
signalling functions of prices in allocating resources
and co-ordinating the decisions of buyers and sellers
                in a market economy

•   A market is place or situation where buyers and sellers interact or communicate
    for the purpose of exchange. Markets require:

•   Consumers create demand i.e. buyers

•   Producers or firms create supply i.e. sellers

•   Examples of markets include:

     – Housing market: home owners and potential buyers
     – Labour market: employers and workers
     – Stock market: share owners and potential buyers
     – Foreign exchange market: trading currencies
Functions of the Price Mechanism

• The price mechanism is the means by which decisions of
  consumers and businesses interact to determine the allocation of
  resources between different goods and services

(1) The Signaling Function
• If prices are rising because of stronger demand from consumers,
   this is a signal to suppliers to expand output to meet the higher
• When demand is strong, higher market prices act as an incentive
   to raise output (production) because the supplier stands to make a
   higher profit

(2) The Rationing Function
• Prices serve to ration scarce resources when demand in a market
   exceeds supply
(1) Signaling Function
  Prices and the Allocation of Resources
         Market for Good B
 Price                        S
                                                     •Price changes resulting from shifts
                                                     of demand cause revenues & profits
    P2                                               to rise or fall.
                                                     •Profits attract capital; losses lead to
                             D1       D2             •Higher wages attract labour and
                                                     encourage workers to acquire skills.
                Q1 Q2
                                                     •At the core of the system, supply,
Good A                            Reallocation of
                                  resources from     demand, and prices in input
                       X          Good A to Good B   (resource) and output (goods and
                                                     services) markets determine the
                                                     allocation of resources and the
                                                     ultimate combinations of things

                                    Good B
(2) Price Rationing

                      •   A decrease in supply creates a
                          shortage at the original price.

                      •   The lower supply is rationed to
                          those who are willing and able to
                          pay the higher price.
(2) Price Rationing

                      • There is some price that will
                        clear any market.

                      • The price of a rare painting
                        will eliminate excess
                        demand until there is only
                        one bidder willing to buy the
                        single available painting.
Adam Smith and the ‘Invisible Hand’

     • The 18th Century economist Adam Smith –
       one of the founding fathers of modern
       economics, described how the invisible or
       hidden hand of the market operated in a
       competitive market through the pursuit of
       self-interest to allocate resources in
       society’s best interest
     • This remains the central view of all free-
       market (‘laissez-faire’) economists, i.e.
       those who believe in the virtues of a free-
       market economy with minimal government

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