1.2.7 Price mechanism – A Level Economics Edexcel A notes

Contents

What is the price mechanism?

The price mechanism is when the price changes to allocate scarce resources through changes in supply and demand.

The price mechanism can be broken down into three “functions”:

• Incentive function – for example, an increase in price incentivises firms to increase production to increase profits. This would lead to a movement along the supply curve.
• Rationing function – a shortage of a good (when demand exceeds supply) leads to a higher price to ration away excess demand. In other words, we see a movement along the demand curve.
• Signalling function – rising prices signal firms to enter the market and consumers to leave the market.

The price mechanism in response to excess demand

The price mechanism helps explain why the free market can eliminate shortages and surpluses.

Suppose, to begin with, the price is at p. This is below the free market equilibrium at p1.

At price p, there is excess demand. In the diagram below, demand is at q2 while supply is at q1.

To remove the excess demand, the functions of the price mechanism kick in.

• Rationing function:
  • As there is excess demand, the price rises to eliminate the excess demand.
  • This leads to a contraction (movement along) the demand curve.
• Incentive function:
  • As the price rises, firms are incentivised to increase supply, owing to the higher profit margin on extra units sold.
  • This leads to an extension (movement along) the supply curve.
• Signalling function:
  • As the price rises, this signals to firms to enter the market or to produce more.
  • Similarly a price rise may signal consumers to leave the market or to consume less.
  • This further leads to an extension in supply and a contraction in demand.

Altogether, the price mechanism enables the market to move from excess demand to the equilibrium at quantity q1 and price p1.

Price mechanism and a fall in price

The price mechanism also works to remove excess supply.

• Rationing function:
  • In this case, the rationing function works in reverse. In the presence of excess supply, the price falls to increase demand and eliminate the excess supply.
  • This leads to an extension along the demand curve.
• Incentive function:
  • The fall in price reduces the incentive for firms to produce, as firms’ profit margins have fallen.
  • So there is a contraction along the supply curve.
• Signalling function:
  • As the price falls, this signals to firms to leave the market or produce less.
  • Also for consumers, as the price falls, this may signal to consumers to reduce their demand or leave the market.
  • This leads to a further contraction in supply and an extension in demand.

Price mechanism following a shift in demand or supply

The price mechanism is also an excellent way to level up any supply and demand analysis.

Suppose the market starts at the equilibrium (q,p). Then there is a shift right in demand.

At the original price p, there is excess demand. Demand, at q2, is higher than supply at q.

So the rationing function kicks in to eliminate the excess demand. This leads to higher prices and a resulting contraction in demand.

The incentive function causes an extension in supply. The signalling function reinforces these effects.

This occurs until the new equilibrium quantity q1 and equilibrium price p1 are reached.

Evaluating the price mechanism

Which factors make it more difficult for the price mechanism to eliminate excess demand or excess supply?

• Supply may not be responsive to price changes for some goods.
  • In housing for instance, the price elasticity of supply is inelastic when it is difficult to source raw materials and workers to build homes.
  • This means the incentive function is weaker. A given rise in price leads to a smaller increase in supply.
• Demand may not be responsive to price changes for some goods:
  • This may apply for necessities such as healthcare, which have price-inelastic demand.
  • A higher price may not always ration demand. Instead, a higher price could increase demand in some circumstances.
    • This could apply to Giffen goods, which are highly inferior goods whose demand rises as price rises. This includes goods like rice and bread.
    • Veblen goods are another example. These goods are seen as status symbols and the higher the price, the greater the status of the buyer. So demand could increase as price increases. An example of this is luxury cars.
    • A higher price may encourage consumers and investors to bring forward demand. This occurs where the higher price today leads consumers to expect prices to rise even more in the future. This could apply to goods such as housing.
• Lack of information prevents firms and consumers from engaging in the incentive, rationing and signalling functions.
• Market failure means prices adjust to a socially inefficient outcome, leading to welfare loss.
• Price controls, such as maximum or minimum prices, can prevent prices adjusting to equilibrium.

The price mechanism in local, national and global contexts

The price mechanism takes effect in local, national and global markets. For example:

• Local – local housing market.
  • There may be high demand for housing in some locations where there are high-paid jobs or good schools.
  • This drives up the price for housing in these areas.
• National – lorry drivers in the UK.
  • There have been difficulties finding lorry drivers in the UK.
  • This has likely contributed to rising wages for lorry drivers.
  • For more, read this article (external link) about lorry drivers and rising pay.
• Global – agricultural products such as oranges.
  • In 2023, there hurricanes and droughts in the countries which grow lots of oranges. This reduced the supply of oranges.
  • This contributed to higher prices of oranges and orange juice in supermarkets across the globe.
  • To read more, see these articles about the price of orange juice here and here (both external links).

Practice question in the style of Edexcel A Economics on the price mechanism

Here is a practice question on the price mechanism. It is written in the style of Edexcel Economics A.

There is a short extract, followed by a practice question.

Extract: House prices have been increasing in cities like New York, London, Zurich and Paris. This has made living in these cities less affordable for those on low and middle incomes. There is also a broader trend of rising house prices over time in the UK. Average house prices in the UK increased from £167,716 in January 2013 to £290,000 in January 2023, a rise of 73%. So, why are houses becoming more expensive?

People may migrate to cities from rural areas or from other countries for job opportunities. Combined with the necessity of housing, this means housing demand is high in urban spaces. Furthermore there is speculation on houses – people may bet that prices keep going up, making potential house buyers want to buy houses before price goes up further. Properties may be seen seen as ways to store wealth, leading to an increase in purchases of property from those with wealth, including spending from abroad. Money flows from abroad to buy London property totalled US$12.4 billion in 2022, though the increase in such flows has slowed following increased economic uncertainty in the UK.

Yet it is difficult to build housing in cities that are already dense and where there is little space for development. In some European countries, regulations on building and zoning laws make it harder to build new houses. High costs of inputs for construction, such as cement, are making it more costly to build new houses. Altogether this makes supply unresponsive to price changes.

Question: Discuss the effectiveness of the price mechanism in allocating housing. (15 marks)

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