RI Price Mechanism its Applications

CONTENTS: LECTURE NOTES • PRICE MECHANISM AND ITS APPLICATIONS (PART 1) o Demand and Supply Model o Price Mechanism in Resource Allocation • PRICE MECHANISM AND ITS APPLICATIONS (PART 2) o Elasticities and its Applications o Impact of Government Intervention o The Labour Market TUTORIAL PACKAGE • Supplementary Worksheets • Section A: Short Structured Questions • Section B: Case Study Questions • Section B: Essay Questions • Section C: Further Reading This series of lectures provides an insight into the workings of the price mechanism in a perfectly competitive market. It focuses on the use of the demand-supply framework and elasticity concepts to analyse product and factor markets such primary products, manufactured product, and the labour market. It also discusses the role of the price mechanism in the efficient allocation of resources. RAFFLES INSTITUTION YEAR 5 H2 ECONOMICS 2025 PRICE MECHANISM AND ITS APPLICATIONS ECONOMICS

RAFFLES INSTITUTION YEAR 5 H2 ECONOMICS 2025 Contents 1. MARKET ECONOMY ................................................................................................ 3 1.1 The Market System ................................................................................................ 3 1.2 The Price Mechanism ............................................................................................ 3 1.3 An Overview of Demand-Supply Model ............................................................... 5 2. DEMAND THEORY ................................................................................................... 7 2.1 Demand .................................................................................................................. 7 2.2 The Law of Demand .............................................................................................. 7 2.3 Movement along vs shifts of the demand curve .................................................. 9 2.4 Factors shifting the market demand curve ........................................................ 10 3. SUPPLY THEORY ................................................................................................... 15 3.1 Definition of Supply ............................................................................................. 15 3.2 The Law of Supply .............................................................................................. 15 3.3 Movement along vs shifts of the supply curve ...................................................... 17 3.4 Factors shifting the market supply curve .............................................................. 18 4. INTERACTION OF DEMAND AND SUPPLY .......................................................... 21 4.1 Effect of Demand Shifts on Equilibrium Price and Quantity .................................... 21 4.2 Effect of Supply Shifts on Equilibrium Price and Quantity ...................................... 22 4.3 Effect of Simultaneous Shifts in Demand and Supply ............................................ 23 5. ECONOMIC WELFARE ........................................................................................... 24 5.1 Consumers’ Surplus .............................................................................................. 24 5.2 Producers’ Surplus ................................................................................................ 24 5.3 Society’s welfare ............................................................................................... 25 6. ROLE OF THE PRICE MECHANISM IN ALLOCATION OF RESOURCES IN A FREE MARKET 26 6.1 How does the Price Mechanism achieve Economic Efficiency .......................... 26 6.1.1 Allocative efficiency.................................................................................... 26 6.1.2 Productive efficiency .................................................................................. 27 6.2 How desirable is the free market equilibrium? ................................................... 27 Appendix A – Self-directed Learning ........................................................................... 28 Appendix B – Economic Systems ................................................................................ 30 PRICE MECHANISM AND ITS APPLICATIONS (PART 1)

Lecture Objectives: After this series of lectures and tutorials, students should be able to: ▪ Explain how the price mechanism allocates resources in a free market ▪ Identify the determinants of demand and supply, and explain how they influence demand and supply ▪ Explain and analyse how prices are determined by free market forces of demand and supply ▪ Explain how changes in demand and/or supply may cause a market to be in disequilibrium and how prices adjust to restore equilibrium (i.e. price adjustment process) ▪ Apply demand and supply analysis in various markets

Year 5 H2 Economics 2025 Price Mechanism and its Applications (Part 1) © Raffles Institution 3 1. MARKET ECONOMY 1.1 The Market System In the free market system (free of government intervention), resources are allocated according to the market forces of demand and supply. It is the level of demand and supply of each factor of production or final good/service that determines their respective prices and quantities traded. Households are consumers of final goods/services, and their consumption decisions give rise to the market forces of demand. Firms are producers of goods/services, and their production decisions give rise to the market forces of supply. The coming together of buyers and sellers to transact goods/services is known as a market. In a free market system, resources are allocated according to the market forces of demand and supply. The following characteristics are necessary for the market -based economy to allocate resources efficiently: ▪ Perfect Competition Perfect competition is an essential feature of the free market economy. In perfect competition for each type of good/service, there are many buyers and sellers, each having an insignificant share of the market. No single buyer or seller is strong enough to control a market and exploit other sellers or buyers. ▪ Rational Behaviour and the Pursuit of self-interest Consumers and producers are assumed to behave rationally. Economic activity in the free-market system is driven by self-interest. Producers or firms try to maximise profits, while consumers try to maximise utility. ▪ Freedom of choice and enterprise All decisions are made by households and firms. Consumers are free to decide what to buy with their incomes. This is known as consumer sovereignty. Firms are free to choose what to sell and what production methods to use. ▪ Private ownership of property Individuals have the right to own, control and dispose of land, capital and natural resources. Owners of factors of production have the right to the income (in the form of rent, interest and profits) earned from the use of these factors of production. 1.2 The Price Mechanism The price mechanism operates in market economies where changes in prices (resulting from changes in demand or supply) will cause resources to move in or out of industries. According to Adam Smith (1776) The Wealth of Nations , the price mechanism is the invisible hand that allocates resources, based on the self - interest of consumers and producers, to result in the right mix of goods and services for society. Guided by self -interest, households and firms interact in markets to eventually determine what and how much to produce, how to produce and for whom to produce. Question: Does this happen commonly in the real world? Which market most closely resembles this? Note: There is consumer sovereignty when they influence the production decisions of the econ