Price Mechanism Functions In A Free Market Economy Economics Essay

Question 1

Explain how the price mechanism functions in a free market economy in order to solve the basic economics problem of scarcity.

The concept of scarcity in Economics is based on the fact that the human desires are infinite and insatiable and these desires exceed the production of number of products because of limited resources. The needs of businesses, governments and individuals are never satisfied. Usually the products either deprecate or become obsolete with time and there is a need to substitute them. It is argued that this state of being insatiable is basic human nature. Some say that advertisements are an influential factor in generating new needs. This lust is not only limited to new products or services but also to personal life like need for luxury etc. (Arnold, 2001)

Resources are fewer in number but the demands are infinite. Price mechanism determines the resource allocation in a free market economic system. Desires of consumers are unlimited but the resources are limited. That is why there is a need to balance the allocation of these resources. Usually pricing is used to determine the allocation of resources in competing uses. Any fluctuation in the demand will result in a fluctuation in supply. Price is used as an indicator. Obviously an increased demand will result in scarcity of the product which will increase the price. The supply of these products is increased to meet the needs of the market. Also this will result in an increase in profits for the producers. Similarly the decrease in demand will result in a decrease in supply. The decrease in demand of a product will result in decrease in the profit margin earned through that specific product. So producers decrease the supply of that product and utilize the resources in production of other products that are more in demand. (Krugman, 2009)

Figure 1relationship between demand and price

Pricing method is considered advantageous as it allows the allocation of resources more efficiently. This results in technical efficiency as the products are produced at the lowest unit cost. The producers want to produce the products at the nominal costs in the competitive market. The chances of gaining some profit encourage the producers to reduce costs, introduce new products and increase the production of the current products. It is expected that in the long run this phenomenon will result in production of products at lowest unit cost and allocation of resources will be optimal. (Forstater, 2007)

Figure 2 A fluctuation in demand affects price as well

Allocative efficiency is also adapted by the markets. The demand determines the production or supply of the product. As in the figure above, it can be seen that the increased demand increases the price and a decreased demand decreases the price. Prices are used as indicators to determine where the highest resource allocation is required (usually the products that give highest profit). This creates a unique balance and makes the resource allocation beneficial for everyone. This can be understood by the example of production of laptops. If the demand for laptop increases, laptop manufacturers will increase their productions while the manufacturers of desktop will decrease their production. The production will be according to the demand curve of the market. Which means that the production of most wanted products is increased. Additionally, the market adjusts the changes in demand with the change in supply so that there is no scarcity of any product. (Gwartney, 2005)

Question 2

Using diagrams discuss any three types of elasticity with which you are familiar. Explain why they are important.

Curve’s elasticity can be defined as the level to which supply or demand curve responds to fluctuation in price. Elasticity of different products is different because of the difference in the demand of the product in the market. Essential products like food and clothing are immune to price changes due to the fact that customers will still buy them regardless of price hikes. These products are considered inelastic. On the other hand if the price of a good product or service that is not essential element of day to day life increases, its consumption will decrease. Such products, whose demand or supply changes with the change in price are highly elastic,. (Arnold, 2001)

Elasticity can be calculated by using the equation:

Considering the above equation, if elasticity of the curve is lesser than one; it denotes that the curve is inelastic. If it is equal to or more than one, it denotes that the curve is elastic.(Forstater, 2007)

The slope of curve of demand is negative. If a slight increase in the price of a product results in a huge decrease in the demand, this will result in a flatter or horizontal demand curve. The flatter curve denotes that the specific product or service is highly elastic.

Figure 3 Elastic Demand

On the other hand an upright or slightly vertical curve is used to depict an inelastic demand.

Figure 4 Inelastic Demand

Similarly for supply, for elastic product or service the curve is flat or horizontal. Flatter curve shows that elasticity is greater than or equal to one.

Figure 5 Elastic Supply

For supply, inelastic curve is represented by an upright or almost vertical curve.

Figure 6 Inelastic Supply

A. Factors Affecting Demand Elasticity

Demand’s price elasticity is affected by the following three factors: (Forstater, 2007)

1. The availability of substitutes – If there are alternatives for a service or product, of course its demand will be more elastic. This means that even a slight increase in the price of a product should result in a decrease in demand of that product. Let’s take a scenario of caffeinated drinks. If there is a price hike of say 50 cents for one cup of coffee. It can be substituted by a cup of tea. This makes coffee an elastic good. On the other hand if the price hike is of caffeine (main ingredient of tea and coffee) rather than of the product, it will result in little or decrease in demand of caffeinated drinks (tea or coffee). As, there are no other alternatives for caffeine, this makes caffeine an inelastic products. If a product is unique meaning having no alternatives, it is considered inelastic.

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2. Amount of income available to spend on the good – Demand elasticity is highly dependent on the amount a person can spend on a certain product or service. This means that if the income of a person does not increase but the price of a product increases, the demand of that product will decrease. If the income is stable, then the demand of the product will become elastic.

3. Time – Time is also an important factor that considerably affects the demand elasticity. If there is an increase in price of product say a can of beer. And the consumer finds out he cannot afford to buy 2 or 3 cans of beer at that price in one day. He will reduce the consumption of beer.

B. Income Elasticity of Demand

The second factor mentioned above states that if income tends to stay the same but the price of the product increases, it will result in a decrease in demand. On the other hand increase in income will result in increase in demand. So income elasticity of demand can be defined as the extent to which the increase in income will result in heightened demand of the product. Following equation shows the income elasticity of demand:

ED = Elasticity of Demand

Q = Quantity; Y = Income; EDy = Income Elasticity of Demand

Demand of an item has high income elasticity if EDy is more than one. Demand is considered income inelastic if EDy is lesser than 0 (Arnold, 2001)