The Allocating Function of Prices

b.Suppose that government regulatory authorities imposed a “price floor” on this product of P = $4.What would be the quantity supplied and quantity demanded of this product? How would you characterize the situation in this market?

Solution

a.Equilibrium in this market occurs when,at some price,quantity supplied equals quantity demanded.Algebraically,this condition is given as

QD = QS.Substituting into the equilibrium condition we get

The equilibrium quantity is determined by substituting the equilibrium price into either the demand or the supply equation.

b.At a mandated price of P = $4,the quantity demanded and quantity supplied can be determined by substituting this price into the demand and supply equations and solving:

Since QS > QD,these equations describe a situation of excess supply (surplus) of 5 units of output.

25 3 10 2 - = +P P

P* = = 15 5 3

QD * = - () = - = 25 33 25 9 16 QS * = + () = + = 10 23 10 6 16

QD = - () = - = 25 34 25 12 13 QS = + () = + = 10 24 10 8 18

THE ALLOCATING FUNCTION OF PRICES

While the price rationing mechanism of the market may be viewed as a short-run phenomenon,the allocating function of price tends to be a longrun phenomenon.In the long run,all price and nonprice demand and supply determinants are assumed to be variable.In the long run,price changes signal consumers and producers to devote more or less of their resources to the consumption and production of goods and services.In other words, free markets determine not only final distribution of final goods and services,but also what goods and services are produced and how productive resources will be allocated for their production.

Definition:The allocating function of prices refers to the process by which productive resources are reallocated between and among production processes in response to changes in the prices of goods and services.