Explain how the price mechanism allocates resources in a market economy.

AQA A-Level Economics Paper 1 June 2022

Explain how the price mechanism allocates resources in a market economy. (15 marks)

In the free market, equilibrium is the price and quantity at which demand meets supply. The price mechanism has three functions (ration, incentive and signal) and this solves the basic economic problem and efficiently allocates scarce resources.

1. for example, the diagram on the left shows an initial equilibrium of p1 and q1.
2. if there is a change in the factors of demand, such as an increase in the population, this would cause an increase in demand from D1 to D2.
3. initially, this would cause excess demand as shown between q1 and q2.
4. q2 represents the number of houses that consumers are willing and able to buy at p1 and q1 represents the number of houses that firms are willing and able to sell at p1.
5. the signal function works to inform firms that there is too much demand at this price. for example, firms might notice that there are long queues of customers or busy phone lines.
6. this would incentivise firms to increase prices, as they know that they can earn higher profits.
7. as price increases from p1 to p2, there is an extension in supply and a contraction in demand.
8. the diagram on the right shows a new equlibrium at p2 and q2, where demand meets supply.
9. this meant that the excess demand was rationed away.

1. a similar effect can happen if there is excess supply in a market.
2. the market would signal to firms that there is excess supply.
3. for example, firms would notice that their shops are quiet or that they have a lot of spare capacity.
4. this would incentivise them to lower their prices so that they can sell more goods or services.
5. as the price falls, demand extends and supply contracts.
6. this effect rations away the excess supply and allows the market to settle at a new equilibrium with a lower price and a lower quantity compared to before.

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