2013_IJC_H1_Econs_Q3 Answer

1    3(a) Explain how the price mechanism may allocate resources efficiently. [10] Suggested Detail Essay Outline Step 1: Explain the price mechanism - Define price mechanism, demand and supply The price mechanism is a system where demand and supply interacts with each other to determine the equilibrium price and quantity of goods and services sold in markets. The demand shows the willingness and ability of consumers to purchase a particular good/service at various prices. The supply shows the willingness and ability of producers to produce a particular good/service at various prices. - Explain the role of price mechanism in a free market In a free market, economic agents such as producers and consumers are assumed to act rationally and governed by their self-interest. Pr oducers would aim to maximise profits while consumers would aim to maximise satisfaction. The price mechanism uses price to act as a signal to producers and consumers on how to allocate their resources in order to maximise their own satisfaction. Step 2: Explain how the price mechanism allow producers and consumers to make decision on the allocation of their resource - Explain how the price mechanism address the 3 basic questions on resource allocation what and how to produce and for whom to produce - Basic concept: price mechanism  use price as signalling (what to produce & how to produce) and rationing role (for whom to produce What and How much to produce? In the price mechanism, consumers decide what is to be produced (consumer sovereignty) by exercising their ‘dollar votes’. Producers then respond to the desire of the consumers by producing those goods and services that the consumers demand to maximise their profits. As such, producers then address how much to produce by looking at the prices consumers are willing and able to pay. How to produce? In order to maximise profits, firms will use the least cost method of production to produce the goods for the consumers. For whom to produce? The price mechanism also plays a rationing role in the sense that only consumers who are willing and able to pay for the good/service get to consume it eventually. As such, only consumers with the highest dollar vote get to enjoy these goods/services.

2    Step 3: Explain how the price mechanism always try to reach equilibrium and why the equilibrium is allocative efficient - Explain how the price mechanism allocates resources to achieve equilibrium when there is a shortage or surplus. [Using the case of shortage]: The price mechanism in, using price as a signalling and rationing role in the market economy, will automatically adjust to reach equilibrium. For example, if the price of a good is current ly too low such that quantity demanded exceeds quantity supplied, resulting in a shortage, consumers and producers will begin to respond to the shortage. Due to the shortage, consumers will begin to bid up the price so that they can ge