1.1.5 The Role of Price Mechanism

Syllabus Statement: Explain why scarcity necessitates choices that answer the “what to produce?” question Explain why choice results in an opportunity cost

SCARCITY, CHOICE AND OPPORTUNITY COST IN RESOURCE ALLOCATION

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• Scarcity is a situation that arises when available resources - factors of production - are finite, whereas the needs and wants of society are infinite; hence, the condition of scarcity forces society to make choices about what to produce using limited resources

• As these finite resources must therefore be allocated efficiently to best satisfy the infinite needs and wants of society, there exists an opportunity cost as an alternative choice is foregone for another

• These choices are guided by the signaling function and incentive function of price in the free market

Syllabus Statement: Explain, using diagrams, that price has a signalling function and an incentive function, which results in a reallocation of resources when prices change as a result of a change in demand or supply conditions

PRICES AS SIGNALS AND INCENTIVES IN RESOURCE ALLOCATION

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When the market is at disequilibrium (shortage or surplus), the market can reallocate resources due to the price mechanism:

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• Price has a signalling function to communicate information to decision-makers

• Price has an incentive function to motivate decision-makers to respond to the information

Decrease in Price:

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• When a surplus arises from a decrease in demand or an increase in supply, the subsequent decrease in price acts as both a signal and incentive to consumers and producers:

• Consumers: A decrease in price signals consumers that the good or service is now cheaper, therefore incentivizing consumers to increase consumption from Point A to Point C

• Producers: A decrease in price signals producers that production is less profitable, therefore incentivizing producers to reduce output from Point B to Point C

• This price mechanism results in the reallocation of resources, seen through a change in equilibrium quantity to Point C, the new market equilibrium

Increase in Price:

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• When a shortage arises from an increase in demand or a decrease in supply, the subsequent increase in price acts as both a signal and incentive to consumers and producers:

• Consumers: An increase in price signals consumers that the good or service is now more expensive, therefore incentivizing consumers to reduce consumption from Point A to Point C

• Producers: An increase in price signals producers that production is more profitable, therefore incentivizing producers to increase output from Point B to Point C

• This price mechanism results in the reallocation of resources, seen through a change in equilibrium quantity to Point C, the new market equilibrium