You owe
Green sheet – rhubarb &
   custard – Ec quiz
Price Mechanism
       D & S issues
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)

 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
  In a free market

 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

 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).
  In a free market
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
Owners of FoP’s
   In a free market
 Owners of FoP’s
                       All want the
                      highest return
           Capital      possible on
                       their assets

Labour               Enterprise

Function of Prices…
   In a free market
The 3 Functions of Price

 Rationing

 Signalling

 Incentive

 If there are scarce resources,
  then they need to be rationed
  between the consumers infinite

 Draw an elastic Demand curve
 Draw an inelastic Supply curve

 What would happen under the
  market mechanism if they was a
  fall in supply?

 What has happened along the
  Demand curve?
 How does this link to income
  effect & substitution effect?

 The price of a good sends clear signals to both
  consumers and producers

 If the price is set below the market

 Draw this on a D & S diagram.

 What happens to D & S?

 WHY does this happen?

 Low price tag encourages consumers to buy
  more – it increases your utility or amount of

 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
Exceptions to the laws of demand

  When an increase in price acts encourages
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.
      Multi choice
  Complete your answers on BACK of
       Choose option & explain
(define, formula / calculate, explain)
Your HWK task….

Read chapter 15 in textbook

Complete p 99 Q 2

Flat screen TV’s
      Multi choice
  Complete your answers on BACK of
       Choose option & explain
(define, formula / calculate, explain)
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)
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)
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

 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
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)

To top