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)
The price mechanism has three main functions; signalling, incentivising and rationing.
The diagram below shows how the free market responds to an increase in demand. For example, the demand for housing in London has increased over time, whilst the supply has remained relatively low. Initally, the housing market is at equilibrium with a quantity q1 and price p1. Then, demand increases. This means that there is an excess demand in the market for houses. This is because there is a greater quantity of houses that consumers are willing and able to buy compared to what firms are willing and able to produce. This information will be signalled through the market as firms. For example, estate agents will notice more calls or longer queues than usual. This incentivises producers to raise prices. A higher price has a rationing function as it leads to a contraction along the demand curve (D2). At the same time, the higher price causes an expansion along the supply curve (S1). This means the market reaches a new equilibrium price and quantity, and the excess demand no longer exists.
The diagram below shows how the free market responds to a decrease in demand. For example, the demand for old diesel cars has decreased in London whilst the supply has mostly remained the same. Initally, the market is at equilibrium with a quantity q1 and price p1. Then, demand decreases. This means that there is an excess supply of used diesel cars in the market. This is because there is a greater quantity of diesel cars that firms are willing and able to produce compared to what consumers are willing and able to buy. This information will be signalled through the market as firms. For example, second hand car dealers will notice quieter stores or shorter queues than usual. This incentivises them to reduce prices. A lower price has a rationing function as it leads to an expansion along the demand curve (D2). At the same time, the lower price causes a contraction along the supply curve (S1). This means the market reaches a new equilibrium price and quantity, and the excess supply no longer exists.
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