The Price Mechanism.doc

2. The Price MechanismDemand 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)20406080100Price (cents)2001501006030Demand Curve: A graph of the demand schedule is called a demand curve.SupplyThis 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)8070605040Price (cents)2001501006010Supply Curve: A graph of the above supply schedule is called a supply curve.EquilibriumWhen 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 ProblemWhat 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 produced.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 cost. 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 production.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.MarketA 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 MarketThis 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 MarketEach 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 DemandThe 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 ResourcesA 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 QuestionsMultiple Choice Questions1. 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 its 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 Answer1. 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 que