The Price Mechanism

By Lois Brooks,2014-01-19 02:04
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    2. The Price Mechanism


    This is determined by the consumer and is the amount of a product that a consumer will buy at various prices.

     The following information was constructed from a class activity:

Demand schedule for Mineral Water: A demand schedule is a table that

    shows the relationship between price and quantity demanded.

Quantity Demanded (bottles) 20 40 60 80 100

    Price (cents) 200 150 100 60 30

    Demand Curve: A graph of the demand schedule is called a demand curve.

    Demand Curve








    Quantity Demanded


    This is the amount of a product that a producer is willing to sell into the market at various prices.

    The following information was constructed from a class activity:


Supply schedule for Mineral Water: A supply schedule is a table that

    shows the relationship between price and quantity supplied.

    Quantity Supplied (bottles) 80 70 60 50 40 Price (cents) 200 150 100 60 10

Supply Curve: A graph of the above supply schedule is called a supply


    Supply Curve








    Quantity Supplied


When you plot both curves on the same graph you will discover the

    following diagram:











What is the significance of the point where the two graphs meet?

    It is the point of equilibrium or the point where demand and supply are equal. If you notice the amount supplied by producers and the amount demanded by consumers is equal at this point. At a price of 100 cents the supply of mineral water is equal to the demand for mineral water. This point is called equilibrium. There is no surplus production of mineral water and no shortage of mineral water at this point. Sixty bottles of mineral water will be exchanged at a price of one dollar.

What is the price mechanism?

    The price mechanism explains how the forces of demand and supply determine the four fundamental economic questions. The demand and supply of goods and services will determine an equilibrium price and quantity for all products. The consumer decides how much of a product that they want to buy at various prices. The producer decides how much they want to sell at various prices. When producers and consumers agree and supply and demand are equal there is an equilibrium point at which the market price and quantity are set.

Solutions to the Economic Problem

    What are the four fundamental questions that all economic systems must answer?

    1. What to produce? The economy must decide out of all the products

    that consumers want, which ones will be satisfied.

    2. How much to produce? Once the economy has decided what goods

    are to be produced then they have to decide on quantities. How many

    new cars will be produced?

    3. How to produce? There are many different ways in which a good

    can be produced. The producer has to decide which method is the

    best. The producer can use different raw materials or a variety of

    different production processes.

    4. How to share? Who receives the benefits of production? A society

    needs to have rules on who receives what, from the goods and

    services available from production.


    How does the price mechanism solve these fundamental questions in a market economy?

    A market economy mainly relies on the forces of demand and supply to allocate goods and services.

1. What to produce? One dollar is one vote as to what will be

    produced. The concept of consumer sovereignty explains that the

    consumer is king and that market demand determines what will be


2. How much to produce? This is also determined by consumer

    demand. Consumers will determine the quantity of goods produced

    by buying what they require. Producers will quickly find out these

    quantities. If they produce too little then there will be a shortage of

    the product and the producer will lose potential profit. If there is a

    surplus of production then the producer will have waste and extra


3. How to produce? The producer will use the lease cost method of

    production. They will use the resources that minimize the cost of

    production. A low cost of production will mean that the producer can

    make more profit. They could also sell at a lower price and undercut

    their competitors. Producers are always trying to reduce their cost of


4. How to share? The contribution that a household makes to

    production will determine the amount of income that they earn.

    Households are the owners of resources. They provide labour, capital

    and raw materials. Their income in turn determines how much they

    can spend on goods and services and this determines their share of

    total consumption. When goods are shared amongst members of

    society this is called distribution.



    A market is a network of buyers and sellers. It can be a physical place but this is not necessary. A market exists as long as buyers and sellers can communicate with each other, whether physically or by electronic means.

Product or Goods Market

    This is the market for finished goods and services that are ready to be used by the consumer. Most consumer goods & services are sold in this market.

Factor Market

    Each of the factors of production has its own market and prices for each factor are determined in these markets. The labour market determines the wage rate (price of labour) for each of the various occupations. Each of the different types of raw materials has a separate market that determines its price. Capital and money markets determine the allocation financial resources.

Derived Demand

    The demand for factors of production is determined by the demand for the consumer goods that they can be used to make. The price of gold would rise if there were a significant increase in the demand for gold jewelry. The wages of information technology workers have risen strongly in recent years as a result of greater use of computers in business.

The Allocation of Resources

    A decision to do something is a decision not to do something else. If you use gold to make a statue it is no longer available for use as a ring. This is the concept of opportunity cost. Factors of production can be used in a variety of different ways and society must decide their best uses. The way in which factors are allocated or used is called the allocation of resources. For a

    society to be successful or rational it must have an efficient allocation of resources.

    The need for ensuring efficient allocation or use of resources is a core problem for economics and part of what is called welfare economics. Economists refer to the need for an optimal allocation of resources or simply

    optimality. Optimality occurs when the available resources have been used to achieve the greatest possible utility or satisfaction for the society. An


    optimal allocation of resources has been achieved if it is not possible to make some people better off without making some people worse off to a greater degree.

    Market forces and the rational behavior of consumers and business determine this optimal allocation. A rational businessperson would not use timber to make outdoor furniture if it was cheaper to use metal and consumers were prepared to pay the same price for metal furniture. The higher price of timber reflects the fact that it has other more valuable uses like antique furniture. For this reason a furniture manufacturer would only use valuable timber like Oak to make antique furniture and would not use this wood for packing creates.

    Price signals are important as they affect this allocation process. Consumers make decisions about the goods and services that they consume based on prices. Producers decide which resources to use and which industries to enter based on prices. The forces of demand and supply and the price mechanism determine prices and the allocation of resources. Exam Questions

    Multiple Choice Questions

    1. A good example of derived demand would include:

    a) Increased demand for steel results in more jobs for coal miners. b) More drinks are consumed over summer.

    c) Hot foods are popular in winter.

    d) Both (b) and (c) above.

2. An optimal allocation of resources would imply that:

    a) No person in society could have an increase in utility.

    b) All persons would be worse off if society changed it’s output mix.

    c) Some people could receive an increase in utility only if others lost utility. d) All persons reached maximum satisfaction simultaneously.

    3. In a market economy resources are allocated according too: a) Consumer sovereignty.

    b) Derived demand.

    c) Factor prices.

    d) All of the above.


Short Answer

    1. Define the following terms: demand, law of demand, demand schedule,

    demand curve, supply, law of supply, supply schedule, supply curve,

    equilibrium, equilibrium price, equilibrium quantity, allocation of

    resources, consumer sovereignty, utility and optimal resource allocation.

    _____________________________________________________________ _____________________________________________________________ _____________________________________________________________ _____________________________________________________________ _____________________________________________________________ _____________________________________________________________ _____________________________________________________________ _____________________________________________________________

    2. What four fundamental questions must all economies answer? _____________________________________________________________ _____________________________________________________________ _____________________________________________________________ _____________________________________________________________ _____________________________________________________________ _____________________________________________________________

Extended Response

    How does the market economy solve the economic problem?

Rule 1: Define the terms in the question: Economic problem, market


    Rule 2: Identify & define related concepts: Consumer sovereignty, least cost method of production, contribution to production, four fundamental economic questions, demand & supply, price mechanism, market. Rule 3: Link introduced terms to the question consumer demand

    determines what is produced.

    Rule 5: Draw relevant diagrams: Price mechanism

    Rule 6: Text reference to diagram in your answer: Equilibrium occurs when

    demand and supply are equal this is shown as point A in the diagram. Rule 7: Use examples to communicate additional meaning: A mathematical

    example of the price mechanism.

    Rule 4: Draw logical conclusions: The price mechanism can determine the price of goods and factors of production and this determines the allocation of

    resources in a market economy.


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