Functions of Price

Rationing, signalling and incentives

The interaction of buyers and sellers in free markets enables goods, services, and resources to be allocated prices. Relative prices, and changes in price, reflect the forces of demand and supply and help solve the economic problem. Resources move towards where they are in the shortest supply, relative to demand, and away from where they are least demanded.

The rationing function of the price mechanism

Whenever resources are particularly scarce, demand exceeds supply and prices are driven up.  The effect of this is to discourage demand and conserve resources. The greater the scarcity, the higher the price and the more the resource is conserved. This can be seen in the market for oil. As oil slowly runs out, its price will rise, and this discourages demand and leads to more oil being conserved than at lower prices.

The signalling function of the price mechanism

Price changes send contrasting messages to consumers and producers. Rising prices give a signal to consumers to reduce demand or withdraw from a market completely, and they give a signal to producers that they should increase production or enter the market. Conversely, falling prices give a positive message to consumers, to consume more, but a negative message to producers, the produce less. For example, a fall in the price of PCs relative to laptop computers sends a message to producers to manufacture more laptops.

The incentive function of the price mechanism

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 producers to supply more, or to enter the market, because they provide the possibility or more revenue and increased profits. For example, a rise in the wage rate, which is the price of labour, provides an incentive for the unemployed to join the labour market.

Reading Materials

Students,

Use these links to help with your essay homework.

http://economicsconcepts.com/determinants_of_price_elasticity_of_supply.htm

http://edecon.wordpress.com/2010/05/23/price-elasticity-of-supply/

http://www.intelligenteconomist.com/determinants-of-price-elasticity-of-supply/

http://economicsonline.co.uk/Competitive_markets/Price_elasticity_of_supply.html

http://welkerswikinomics.wetpaint.com/page/Price+Elasticity+of+Supply

Price Elasticity of Supply Slides

http://www.scribd.com/doc/90102500/Price-Elasticity-of-Supply

1st APR Results

No	Name	P1	40%	Data Response	30%	Essay	30%	Total marks P2 (60%)	Total marks P1+P2 (100%)	Total marks for APR (100%)	Total marks (100%)	Grade
		30		20		20
1	NUR FARZANA HAZIQAH BT MD RUDIAN	17.00	22.67	15.00	22.50	4.00	6.00	28.50	51.17	51.17	51	D
2	HJH NURUL AQILAH BT HJ ABDULLAH	14.00	18.67	10.50	15.75	8.00	12.00	27.75	46.42	46.42	46	E
3	SH MD RAIMI QUSYAIRI B SH MAHMUD	11.00	14.67	2.00	3.00	3.00	4.50	7.50	22.17	22.17	22	U
4	SITI KHAIRUNNISA	17.00	22.67	7.00	10.50	6.00	9.00	19.50	42.17	42.17	42	E
5	DK NURUL SAIYIDAH BT PG MD JEFFERY	16.00	21.33	5.00	7.50	4.00	6.00	13.50	34.83	34.83	35	U
6	LIM YEE WEN	13.00	17.33	9.00	13.50	3.00	4.50	18.00	35.33	35.33	35	U
7	LIYANA SAFIYAH BT HJ SIDEK	19.00	25.33	12.00	18.00	11.00	16.50	34.50	59.83	59.83	60	C
8	MD HASRI B HJ HASNAN	17.00	22.67	10.00	15.00	6.00	9.00	24.00	46.67	46.67	47	E
9	MD SYAZWEE B MD	16.00	21.33	7.00	10.50	3.00	4.50	15.00	36.33	36.33	36	U
10	MD KHALID WASSIDI SALLEH	20.00	26.67	12.00	18.00	9.00	13.50	31.50	58.17	58.17	58	D
11	NURUL ATIQAH BT GHANI	15.00	20.00	4.50	6.75	1.00	1.50	8.25	28.25	28.25	28	U

Backward Bending Supply Curve

A typical supply curve shows an increase in supply as price rises. It slopes from left to right.

However, in labour markets we can often witness a backward bending supply curve.

Diagram of Backward Bending Supply Curve

The reason is that there are two effects related to determining supply.

The Substitution effect states that a higher wage makes work more attractive than leisure. Therefore, supply increases.

The income effect states that a higher wage means workers can achieve a target income by working less hours. Therefore, because it is easier to get enough money they work less.

When your wage is low, the substitution effect dominates. As wages increase, the income effect starts to dominate.

Importance of Elasticity

(i) Importance in taxation policy. As regards its practical advantages, the concept has immense importance in the sphere of government finance. When a finance minister levies a tax on a certain commodity, he has to see whether the demand for that commodity is elastic or inelastic.

If the demand is inelastic, he can increase the tax and thus can collect larger revenue. But if the demand of a commodity is elastic, he is not in a position to increase the rate of a tax. If he does so, the demand for that commodity will be, calculated and the total revenue reduced.

(ii) Price discrimination by monopolist. If the monopolist finds that the demand for his commodities is inelastic, he will at once fix the price at a higher level in order to maximize his net profit. In case of elastic demand, he will lower the price in order to increase his sales and derive the maximum net profit. Thus we find that the monopolists also get practical advantages from the concept of elasticity.

(iii) Importance to businessmen. The concept of elasticity is of great importance to businessmen. When the demand of a good is elastic, they increases sale by towering its price. In case the demand' is inelastic, they are then in a position to charge higher price for a commodity.

(iv) Help to trade unions. The trade unions can raise the wages of the labor in an industry where the demand of the product is relatively inelastic. On the other hand, if the demand, for product is relatively elastic, the trade unions cannot press for higher wages.

(v) Use in international trade. The term of trade between two countries are based on the elasticity of demand of the traded goods.

(vi) Determination of rate of foreign exchange. The rate of foreign exchange is also considered on the elasticity of imports and exports of a country. 

                                               .

(vii) Guideline to the producers. The concept of elasticity provides a guideline to the producers for the amount to be spent on advertisement. If the demand for a commodity is elastic, the producers shall have to spend large sums of money on advertisements for increasing the sales.

(viii) Use in factor pricing. The factors of production which have inelastic demand can obtain a higher price in the market than those which have elastic demand. This concept explains the reason of variation in factor pricing.

Model Essay

“The Central Problem of Economics is scarcity and choice.” Is this statement true? (25)

Scarcity is defined as a situation in which resources are not enough to satisfy everybody’s wants. The outcome of satisfaction is not to the level we want it to be. Scarcity is the most fundamental concept in Economics. Scarcity is based on a few assumptions.

First, is that man’s wants are unlimited. Man is never satisfied with his current level of consumption, and he always wants more. Second, is that the world’s resources are limited. These resources are the factors of production of land, labour, capital and entrepreneurship. Land refers to natural resources and all the fruits of the earth. Labour refers to human effort and skill. Capital refers to any machine or technology that can produce things. Entrepreneurship is the ability to take risks, organize and plan production effectively. All countries have a finite amount of these.

Based on these assumptions, it is clear that it is not possible to produce all that we want. Some goods will have to be sacrificed to obtain more of other goods. This means that a choice has to be made.

To illustrate this concept, a man has a certain amount of money to spend. He decides to spend it all on sweets and chocolates. He can spend half his money on sweets, and the other half on chocolates. If he wants more sweets, he will have to give up some chocolates and vice versa. In the same way, for a firm, its resources are limited. If it decides to produce more of product A, it has to give up some production of good B. Thus, scarcity applies both to consumers and producers.


Figure 1: Production possibility curve
The Production Possibility Curve (PPC) further illustrates scarcity. The PPC shows all the possible combinations of 2 goods which a firm can produce, given a fixed amount of resources. At combination a, the producer can produce 100 units of X and 0 units of Y. While at combination b, he can produce 200 units of Y and 0 units of X. He may also choose to produce at c, 70 units of X and 150 units of Y. All these combinations are possible combinations of goods that can be produced. To produce more of one good, the other has to be sacrificed. Combinations d and e are not attainable, which also shows scarcity. It is the same at country level.

Scarcity forces us to choose. Since we cannot have everything, we have to decide on which one we will have to forgo. Since comething has to be forgone, there is a cost involved. In a world of scarcity, there is a cost of sacrifice involved in satisfying a particular want. This cost is called opportunity cost, and is defined as the highest valued alternative that had to be foregone to satisfy the particular want.

The basic economic problem is scarcity. Because of scarcity, we have to choose carefully on the use of our limited resources. The consumer faces the problem of satisfying his unlimited wants. He wants to have infinite satisfaction, from his finite purchasing power. Scarcity makes this impossible. As such, he will have to make a choice, based on relative opportunity costs, on which goods and services he will spend. He will have to decide which goods he has to forego and which he wants to consume.

For a producer, he will want to make infinite profit, using his finite resources. Likewise, scarcity makes this impossible, and he will have to make a choice, based on relative opportunity costs, on which good he wants to produce.

From a Macroeconomic perspective, the basic Macroeconomic concerns of the government are inome distribution and economic stability. The relative weightage given to these concerns will determine what type of policies the government decides to employ.

Income distribution is important to create a ‘fair’ and a ‘just’ state. This is a Macroeconomic objective, and it requires government intervention through progressive taxation, social insurance, benefits, etc. Reducing large income gaps and poverty are important goals of development and are hallmarks for civilised society. Extreme inequality and widespread poverty can result in social unhappiness and unrest, which in turn will result in political and social instablilty. The crime rate rises, illiteracy goes up, welfare costs rise, which all put a great strain on the economy.

The concept of scarcity comes into play here. Scarcity means that the resources of a counry are limited. As such, every available resource must be used to its fullest potential.The government needs to appreciate this when deciding the level of income equality it hopes to achieve.

If the poor are to be given a lot of financial aid, they may be spurred to further improve their skills, and contribute more to the economy. As the saying goes, a happy worker is a good worker. Likewise, if the poor are left behind as the country prospers, they may feel alienated. As such, they may refuse to work and may even resort to illegal activities. Since the country’s population is limited, a waste of scarce resources would be disastrous.

However, if too much aid is given to the poor, and too much money is taken from the rich, a whole new set of problems may arise. The poor may start to become over-dependent on government aid. This is the situation currently occurring in many Western developed countries. The poor live off their welfare payments and they contribute nothing in return to society. To support such high amounts of aid, the rich would have to be taxed a high amount, which may result in great unhappiness and discontent. This may result in the rich evading tax payments or even force them to migrate to other countries that tax less. This scenario too would be detrimental to the economy as the government would receive lesser tax revenue.

The concerns highlighted above mean that the government will have to make tough decisions. The government will have to decide on the best policy based on the opportunity cost of the available measures.

In a free market economy, the pricing system is prone to high unemployment, inflation and Balance Of Payments (BOP) difficulties. Hence, the government seeks to stabilise the economy. In this, it has four aims.

First, is full employment. Unemployment wastes sarce resources, as stated above, and brings hardships to those without jobs. Full employment is not equal to zero unemployment. It is the employment level asociated with some frictional unemployment.

Second, is price stability. This provides a stable environment for investment and growth. Price stability is not zero inflation, but usually refers to 2-3% mild inflation that is necessary to stimulate growth.

Third, is a healthy BOP. This is to ensure healthy reserves and a stable exchange rate. Last is economic growth, which is the increase in real national income per capita, which should ensure higher living standards.

Ideally, the government would seek to achieve all these aims. However, this is not always possible. Sometimes, to achieve one aim, another has to be compromised. For example, there is large-scale unemployment due to the lack of demand. To counter this, the government will employ an expansionary fiscal policy to boost demand. Government spending on public projects will increase to boost demand. However, this may, in turn, cause demand-pull inflation.

Thus, the concepts of choice and cost come into play again. The government will have to make choices based on the costs of the different measures available. Hence the statement “The Central Problem of Economics is scarcity and choice” is true.

Hints for 1st APR

http://www.cliffsnotes.com/study_guide/Economic-Analysis.topicArticleId-9789,articleId-9726.html

http://levilovesenglish.blogspot.com/2010/12/pros-and-cons-of-agricultural-subsidies.html

http://www.freeeconhelp.com/2011/10/why-marginal-benefit-equals-marginal.html

Marking Scheme for Nov 2009 9708/21

Hello guys,

Here's the answers for yesterday's classwork. Hope u attempted all first before checking the answers here.

1 (a) (i) State the formula used to calculate income elasticity of demand.            [2]

            YED = % change in Quantity demanded
                      __________________________
                              % change in Income

        (ii) What can be concluded about air travel from Fig. 1?                            [2]
           
              Air travel is a normal good since YED is +1.1. It is income elastic because a change in
              increase will cause demand for air travel to increase by more than a proportionate change in
              income.

    (b) Using Fig. 2, explain a likely reason for the different price elasticity values for

         (i) business flights compared with leisure flights                                       [3]

              Business flights have a PED of 0.3 and 0.7 for long distance and short distance respectively.      
              This means that business flights are more inelastic than leisure flights. A likely reason for this
              is, there is no choice or substitutes for time of travel or destination and any price increase will
              be borne by the traveller's firm rather than the traveller. Thus, demand for business flights are
              more inelastic.

          (ii) long distance flights compared with short distance flights                  [3]

               Long distance flights have a PED of 1.3 and short distance flights have a PED of 2.2 which
               means that long distance flights is less elastic than short distance flights. The likely reason for
               this is, fewer substitutes exist for long distance flights and usually involves longer time
               periods and higher costs thus making price rises less significant in total cost.

      (c) Explain the significance of the price elasticity values in Fig. 2 for an airline considering a policy
           of fare cutting.                                                                                       [4]

           Cutting fares will increase revenue when demand is elastic but not when demand is inelastic or
           unitary elastic. It will raise revenue with short distance leisure flights but not with long distance
           leisure flights. It will also not raise revenue with the two types of business flights.

      (d) Discuss the costs and benefits of an increased demand for air travel       [6]

            Increased demand for air travel will benefit businesses where profits will increase and there will
            be possible expansion in business and new markets. Individuals will also benefit through
            increase mobility, leisure and employment because as businesses expands more labour is
            needed. The economy will also benefit in terms of growth.

            The costs, however, will include negative externalities such as pollution, noise and visual
            intrusion. The depletion of resources is also another cost in terms of the fuel and tyres an
            aircraft needs.

             

Cross and Income Elasticities

The Price Elasticity of Demand 3 - Straight Line Demand Curve

The Price Elasticity of Demand 2 - Calculations

The Price Elasticity of Demand 1 - Overview

Appreciation and Depreciation

Click the link below to understand appreciation and depreciation better.

http://www.unc.edu/depts/europe/euroeconomics/Appreciation%20and%20Depreciation.php

Slides on Elasticity

Good Evening Students,

Tomorrow we will learn about elasticity. I got the slides from www.bized.co.uk. Here's the link. http://www.scribd.com/doc/87805775/Elasticity

See u tomorrow!