Explain how the price mechanism allocates resources and describe some of

its advantages and disadvantages (12)

Under a free market economic system, resources are allocated according to the
price mechanism. Consumer wants are infinite and resources are scarce,
therefore these scarce resources need to be allocated between competing uses. On
e
way is this done is through price.

Price acts as a signal to producers. In a market economy, changes in demand
eventually bring about changes in supply. If consumer demand for a product
increases, the resultant shortage will cause the price to increase. As producers
of
the product can now make more profit on this good they will switch more
resources into the production of the good (as they are profit maximisers),
therefore the increase in demand leads to increases in supply and vice versa. If

consumer demand for a product falls, the resultant glut/surplus will cause its
price to fall resulting in a fall in the profit made on the good. Resources are
then
moved out of the production of that particular product and used to produce those

products that are now relatively more profitable.

One of the most cited advantages of the price mechanism is that it best achieves

an economically efficient allocation of resources. Technical efficiency is
achieved as producers produce at minimum unit cost, in other words, when the
fewest necessary resources are used to produce each product. This is because
firms are profit maximising and given the degree of competition in a free
market they will want to produce at a point where costs are minimized. There is
a greater incentive for firms to cut costs, increase productivity and develop ne
w
products because of the chance of extra profit. In the long run (because of the
high
degree of competition), firms are producing at the lowest point in the average c
ost
curve. If all firms operated under these conditions it would follow that there
would be an optimum allocation of resources and every commodity would be
produced at a minimum cost per unit.

Markets also tend towards allocative efficiency. Customers are able to cast thei
r
spending votes in the market. This determines what is produced. Prices signal
the value of individual resources and resources flow to where they yield the
highest profit. In other words, the invisible hand of the market would allocate
resources to everyones advantage. For example, if consumers want to buy more
I-pods and fewer CDs, then I-pod firms will expand production, whilst
manufacturers of CDs will cut production. All firms would be producing to
consumers demand curves i.e. goods which people desire. Furthermore, the market
is flexible so that changes in demand quickly bring about changes in supply so
surpluses / shortages do not last.






Define the price
mechanism fully


















Describe the first
advantage of the
price mechanism














Describe the
second
advantage of the
price mechanism
One of the disadvantages of the having the price mechanism allocating resources
is that it does not always operate smoothly. In a market economy an
individuals ability to consume goods & services depends upon his/her income.
An unequal distribution of income and wealth may result in an unsatisfactory
allocation of resources. The relatively poor do not have access to the range of
goods and service consumed by average citizens. High inequality may also
lead to social exclusion and encourage crime with negative consequences for all.

The market system will not respond to the wants of those with insufficient
purchasing power because what matters in a market based system is your
effective demand for goods and services. Therefore, government may intervene
by providing merit goods such as education and healthcare, and benefits such as
Job Seekers Allowance, child benefit, etc. The finance comes out of taxation,
much of which bears more heavily on the rich.

The price mechanism also fails to take into account market failure. In a free
market, the costs which a firm takes into account when making decisions are
those which it has to pay, i.e. private costs. Similarly a consumer when making
decisions about what and how much to buy only considers private benefit, i.e. th
e
benefit (utility) which he receives. However, the production and consumption of
a product may have spillover effects on people not directly involved in its
production or consumption. These spillover effects are called external costs and

benefits.
























Describe the first
disadvantage of
the price
mechanism















Describe the
second
disadvantage of
the price
mechanism

Explain the difference between scarcity and a shortage (8)

Scarcity is the basic economic problem which arises because human wants which
are unlimited, exceed the goods and services which can be produced at any one
time because of finite resources.

Individuals, businesses and governments always want more. Their wants are
insatiable because goods eventually wear out and need to be replaced i.e.
electronic appliances. New or improved products become available i.e. mobile
phones. Some people argue that the desire to consume is innate and it is human
nature that once one want is satisfied, they want more. Others argue that
advertising plays a powerful role in creating new wants i.e. downloadable ring
tones like Crazy Frog. It is important to note that the concept of unlimited
wants is not only confined to goods and services, but other items such as a bett
er
environment, more leisure time, better relationships, etc.

Resources are limited in relation to the demands placed on them. For example, th
e
total surface area in the world is fixed, and many natural resources are non-
renewable like oil. Indeed, over-fishing in Scotland led to a ban on Cod fishing

in the North Sea. There are limited supply of workers and risk takers. Indeed,
this point was highlighted on the front cover of the Economist in October 2006
with articles on the shortage of talent. With regards to capital, there is a limit

to how much investment a firm can make.

Shortage arises when the demand for a product at a particular price cannot be
met i.e. when demand exceeds supply the quantity which consumers want and
are able to buy is not being produced. In a market economy, shortages usually
dont last long and will be cured by a rise in price and/or an increase in supply.

Demand is a want backed up by the ability to pay and is therefore limited by
income. Scarcity is different because we talk about unlimited wants (not
demand) and how they are never fully satisfied. If there was no shortage there
would still be scarcity because of all those consumers who want the product but
cannot afford to pay.











Define scarcity





State why wants
are unlimited
provide
examples.









State why
resources are
limited provide
examples.







Define shortage
and state the
difference
between it and
scarcity.