Market Forces and Resource Allocation

Geoff Riley, Tutor2u

The Price Mechanism

What is the price mechanism?The price mechanism describes the means by which millions of decisions taken by consumers and businesses interact to determine the allocation of scarce resources between competing uses

Functions of the price mechanism

• Rationing function–Prices ration scarce resources when

demand outstrips supply–When there is a shortage of a product, the

price will rise and thus deter some consumers from purchasing the product

Functions of the price mechanism

• Signalling function– If prices are rising because of stronger

demand, this is a signal to suppliers to expand output if they can– The ability to expand or contract production

depends on the price elasticity of supply

Functions of the price mechanism

• Incentive function–Higher market prices act as an incentive to

raise output because the supplier stands to make a higher profit

Conditions required for competitive markets

1. Consumers have power to allocate resources – i.e. The monopoly power of sellers does not impact too much on consumer sovereignty

2. No externalities from production or consumption3. Full information available to all market participants4. Factors of production are occupationally and

geographically mobile between different uses

The breakdown of these assumptions can lead to market failure & inefficiency

Market Forces – Changes in Demand

Price (P)

Quantity (Q)

D1D2

S1

P1

P2

Q1 Q2

Market Forces – Changes in Supply

Price (P)

Quantity (Q)

D1

S1

P1

P2

Q1 Q2

S2

Revision Quiz on Supply and Demand (Click)

The power of market forces

• Market forces are frequently a powerful way of allocating and reallocating scarce resources

1. Higher prices boost production and investment, dampen demand and help to eliminate shortages

2. Lower prices - e.g. Driven by technological change and economies of scale – expand the size of the market and make products more affordable

3. There are self-equilibrating forces in markets – reflecting the millions of decisions of consumers and producers

4. Even market speculation can be regarded as a stabilising force in many cases e.g. Short selling of bonds & stocks

Quiz – Markets in Action (Click)

When markets work well....

• Competitive markets produce an efficient allocation of scarce resources– Allocative efficiency (producing what we need and want)– Productive efficiency (pressure to lower unit costs)– Dynamic efficiency (innovation, choice, product

performance)

• The price mechanism stimulates – Investment– Higher productivity– Improvements in non-price aspects of goods and services

When markets fail ......

1. Failure to take into account consumption and production externalities

2. Distortion of price mechanism through monopoly / market power of some sellers

3. Imperfect information / information failures and asymmetries4. Immobility of factors of production5. A lack of equity in the final distribution of income and wealth (

relative poverty / inequality)6. Failure to provide public and merit goods in sufficient quantities

and at prices that maximise social welfare7. Unstable market prices creating uncertainty and damaging

producer and consumer welfare especially in vulnerable economies

Government Intervention Quiz (Click)

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