Price signalling

Syllabus: Explain, using diagrams, that price has a signalling function and an incentive function, which result in a reallocation of resources when prices change as a result of a change in demand or supply conditions.

Resource allocation - the importance of price as a signal

$S:\TripleA\Design\icons\small\key_terms.gif$ Price Signalling function - you can use ESEPME to answer questions on price signalling to producers (the role of price in resource allocation)

In a market economy, prices perform a signalling function - prices adjust to show where resources are required (price increase) and where they are not (price decrease)

$S:\TripleA\Design\icons\small\key_terms.gif$ Price Incentive function - ESEPME again but this time effect of price changes on consumers (demand)

Prices also perform an incentive function. As prices rise or fall, this provides an incentive for consumers to purchase less/more (as the price to benefit ratio) falls/rises).

How to define an economy

$S:\triplea_resources\DP_topic_packs\economics\student_topic_packs\media_microeconomics\images\dollar_symbol.jpg$ The central problem of economics is one of scarcity of productive resources relative to the unlimited potential demand that could be made upon them. It therefore follows that every society, be it centrally planned or based upon markets, has to have some mechanism (system) by which its resources, that is its land, labour and capital, are allocated amongst all the numerous uses to which they could be put.

Definition: An economy is a set of systems to allocate scarce resource

cf. Free Market economy (allocation by the market - price - mechanism)
Command economy (Centrally Planned Economy - allocation by the state - Socialism)
Mixed economy (both price mechanism and state allocations side by side)

So, by what process are resources deployed so as to ensure that consumers obtain exactly the right amounts of frying pans, ice creams, jeans etc. that they require? Well, under a system of central planning the answer is not too difficult to ascertain - the state planning authority decides upon its priorities and directs resources to those lines of production which are deemed to be most important;

but, in the free market how do consumers magically obtain those goods that they want in just the right quantities? Here the answer is slightly less obvious - essentially, it is through the interaction of demand and supply. How exactly does this interaction perform the allocative function? Yes - ESEPME - did I mention how important it is to know, remember and understand this process in detail?

The short answer to the above question is that it is through changes in prices. These changes in price indicate and motivate - this is called the signalling and incentive functions. Changes in price indicate the relative strength of consumer demand and signal to producers the changes in demand for their goods or services. Prices also indicate changes in supply that enable producers to signal to consumers what is available on the market and on what terms. Rising prices of goods motivate producers to respond to increases in demand by increasing supply; producers will decrease supply when prices fall because of, ceteris paribus, the effects on profit. You see more clearly how this works when you see how the market forces of supply and demand interact to determine price (ESEPME).

Microeconomics

Table of Contents

Price signalling

Resource allocation - the importance of price as a signal