The Price Mechanism

EdExcel Economics 1.2.7

Lesson Objectives:
● Understand the rationing,
signalling and incentive functions
of the price mechanism for
allocating scarce resources
● Understand the price mechanism
in the context of local, national
and global markets
 Main Functions of the Price Mechanism
In any economy, many decisions on how to resolve the issues of
opportunity cost and trade-offs are resolved by prices.
1. Allocate – allocating scarce
resources among competing uses
2. Rationing – prices serve to ration
scarce resources when market
demand outstrips supply Prices send
important signals
3. Signalling – prices adjust to
demonstrate where resources are
required, and where they are not
4. Incentives – e.g. when the price of
a product rises, quantity supplied
Prices change incentives
increases as businesses respond! for consumers and
suppliers
 Allocating Resources
At the equilibrium, consumer surplus is RSP, producer surplus is QRS
Price
R Consumer and producer
surplus are maximised at
Supply the Market Equilibrium
Consumer (MC)
surplus S
P

Producer
surplus Demand When this is achieved, the
(MB) market is maximising
society welfare.
This is known as
Q
ALLOCATIVE EFFICIENCY

O
T Quantity
 The Rationing Function
The rationing function - when there is a shortage of a product, price
will rise and deter some consumers from buying the product
Higher food prices Rising cost of renting
Price S2 S1

P2 In recent years the

steep rise in food
prices plus
P1 declining real
incomes has
highlighted the Online auctions Tickets for major event
rationing function
of the price
mechanism

D1
Quantity
 The Signalling Function
The signalling function - changes in price provides information to
both producers and consumers about changes in market conditions
Coffee farmers Shale oil and gas
Consider the price signals in this example
“Cotton farmers hit hard as prices drop to
lowest since 2009” (December 2014)

Plentiful global supplies of cotton thanks to

favourable weather caused cotton prices to fall
to a 5 year low in 2014. China’s farmers
Share prices send benefited from a $5bn scheme which ran from
signals Interest rates on loans 2011-14 where the government purchased
cotton at a minimum price, building up a huge
stockpile — China’s reserves rose six-fold
between 2010 and 2014 and it held 60% of the
world’s cotton inventories. The slump in prices
was badly felt by growers in the southern
African country Zambia whose cotton industry
employed a fifth of the population.
 Causes of Price Volatility – Supply & Demand Analysis
An adverse supply shock can cause Rising market demand can also
market prices to rise sharply cause price spikes – especially
especially when PED is low (<1) when supply elasticity is low

Price S2 S1 Price S1
P2

P2
P1

P1

D1 D1 D2

Qty Qty
Price Volatility – Crude Oil Prices (US $s)
The price of oil might drop if actual
demand is lower than forecast and
supply conditions are more favourable

Price
S1
P1
S2

P2

Demand
Forecast
Demand
Actual

Qty
Price Volatility – Sugar Prices Falling Fast
• The world sugar price has
been falling in recent years
• The main factor has been
much stronger supply
helped by favourable
weather conditions and by
the lagged effects of the
high prices in 2012 and
2013
• Brazil, India, China and
Thailand are the main
sugar-producing nations
• Demand growth has
slowed down in part due
to health concerns in many
advanced countries
 Elasticity and Price Changes – Quick Summary
Elasticity of demand and/or supply determines how much a shift in
market conditions changes equilibrium quantity versus price

Change in market conditions

• If Demand increases and Supply is perfectly inelastic (PES=0),
then price rises and quantity doesn't change
• If Supply increases and Demand is perfectly inelastic (PED=0),
then price falls and quantity doesn't change

• If Demand increases and Supply is perfectly elastic, then price

stays the same and quantity rises

• If Supply increases and Demand is perfectly elastic, then price

stays the same and quantity rises
 Shrinking Market Demand for Film Video Rentals
The volume of films rented from UK retail stores has fallen sharply

Falling cost of fast broadband

Film rental market • Increase speed of downloads
volume in the UK • Shift in consumer preferences
2001-2013

Annual rentals (millions) Recovery in live cinema visits

• Investment in digital projection
2001 198
• Greater use of dynamic pricing
2004 159

2007 92 Film rentals seen as inferior good

2010 84 • Preference to download or buy
• Real incomes rising, demand for rentals
2013 53 falls (negative income elasticity)
 Prices in Action: Average Diesel Price in the UK

The average market price for diesel has been declining steadily over the last two
years. The main reason has been the sharp drop in world oil prices. Intense
competition among petrol retailers has also led to some price reductions.
 Rising Prices for Olive Oil
Extract Q: Explain why the price of olive oil has risen
The price of premium virgin olive
oil has risen to $4,282 a tonne in A: An inward shift of market supply causes
November 2014, the highest since increased scarcity - drives prices higher. PED
2008. likely to be low which amplifies price rises

A severe drought in Spain and a Q: To what extent might the rise in the price of
fruit fly infestation in Italy have olive oil lead to a rise in the price of olive oil in
caused a surge in the price of olive UK supermarkets?
oil. The two countries normally
account for just under 70 per cent A: There are few processing costs so a rise in
of output. olive oil prices should feed through quickly
But…
If prices remain high, consumers • Other costs may be falling e.g. bottling,
may continue to switch towards wages, distribution etc.
cheaper substitutes such as soya, • Supermarkets may maintain prices and be
palm and rapeseed oil. prepared to sacrifice some profits.
• A rise in the £/Euro exchange rate may
Source: Newspaper reports prevent a price rise as imports are cheaper
The Price Mechanism

EdExcel Economics 1.2.7

Lesson Objectives:
● Understand the rationing,
signalling and incentive functions
of the price mechanism for
allocating scarce resources
● Understand the price mechanism
in the context of local, national
and global markets