Ayman Alam
Economics Notes
25/10/17
UNIT 10 – MERITS OF THE MARKET SYSTEMS Reallocation of Resources The use of resources will be depended on the consumer demand and costs of production, i.e. if the demand for a good is rising then resources will move towards producing that product and vice versa. The following two diagrams illustrate how changes in demand cause prices to change. These changes in price motivate profit seeking firms to allocate more of their resources from sea travel to air travel.
Fig. 1 Decrease in Demand for air travel
Fig. 2 Increase in Demand for sea travel
Price changes send contrasting messages to consumers and producers about whether to enter or leave a market. Rising prices give a signal to consumers to reduce demand or withdraw from a market completely, and they give a signal to potential producers to enter a market. Conversely, falling prices give a positive message to consumers to enter a market while sending a negative signal to producers to leave a market. The signalling function is associated with shifts in demand and supply curves. An incentive is something that motivates a producer or consumer to follow a course of action or to change behaviour. Higher prices provide an incentive to existing producers to supply more because they provide the possibility of more revenue and increased profits. The incentive function of a price rise is associated with an extension of supply along the existing supply curve. A supply shock reduces supply at each and every price. This may result in a shortage with demand exceeding supply at the existing price, as shown in Fig. 3. Excess demand drives up price to P1, this forces consumers to cut back on demand from e to e2 due to the rationing effect, and encourages producers to supply more from e1 to e2 due to incentive effect. At e2, the market clears with demand equalling supply through a contraction of demand and an extension of supply, as illustrated in Fig. 4. In the long run, the higher price sends out signals, either for existing firms to introduce better production methods or to new firms to enter the market. This increases supply and causes the supply curve to shift to the right. While, consumers leave the market to look for cheaper substitutes, which decreases demand and shifts demand curve to the left, as shown in Fig. 5. Š Niaz Mahmud
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niaz.mahmud@gmail.com niaz@harmonicinvestment.com
Ayman Alam
Economics Notes
Fig. 3 – Initial response to decrease in supply
25/10/17
Fig. 4 – The market clearing
Fig. 5 – Signalling Effects
The Importance of Competition and Incentives One of the benefits of a market system is consumer sovereignty. This allows the consumers to decide what is made and also to choose from a large number of producers, with producers competing with each other to meet this demand. Firms will engage in either actual or potential competition. When there are rival firms in the industry, firms are said to be in actual competition, while, the possibility of firms entering or leaving the industry makes it a potential competition.
© Niaz Mahmud
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niaz.mahmud@gmail.com niaz@harmonicinvestment.com