2013_AJC_H1_Econs_Essays

H1 Prelim 2013 Essays Suggested answers © Anderson Junior College Economics Department Page 1 Question 3 a. Explain how the price mechanism allocates scarce resources in an efficient manner. [10] b. Discuss the difficulties of achieving this in practice. [15] Scarcity is the situation that exists when there is insufficient amount of resources to produce all goods needed to satisfy unlimited wants. Most economies seek to address three basic economic questions – ‘What to produce’, ‘How to produce’ and ‘For whom to produce’. In a market where the government does not intervene at all, the price mechanism seeks to address the above basic economic questions by determining the prices of goods and services and factors of production through the interaction of the forces of demand and supply. Demand refers to the willingness and ability of consumers to purchase a particular good or service at various prices per period of time, ceteris paribus. The supply of a good is the amount of the good that producer s are willing and able to offer for sale at various prices per period of time, ceteris paribus. The basic principle underlying the price mechanism is that goods and services are provided through the market and that consumers and producers act in their self-interest. On the supply side are profit -maximising producers who will provide a certain good or service if the revenue they receive is equal to the cost of producing an additional unit of that good or servi ce (i.e. MR = MC) . On the demand side are consumers who will acquire a certain good or service to maximise their satisfaction if the price they have to pay is equal to the utility or benefit derived from consuming an additional unit of that good or service (i.e P = MU). The price thus acts as a signal which consumers send to producers indicating their demand for a good and producers will allocate resources among competing needs to the production of these goods most desired by consumers, backed by their ability to pay. In this way, the price mechanism plays the allocative and rationing function. Prices perform a signalling function. Market prices will adjust to reflect where resources are required and where they are not. In deciding on what to produce, consider crops such as corn which could be used to produce either biofuel or breakfast cereals. Biofuel and food are goods in competitive supply. Demand for biofuel has been growing in recent years due to greater acceptance of it as a viable s ource of fuel in place of oil. Referring to Figure 1(a), the increase in demand for biofuel causes the demand curve D1 to shift to D2. Without a change in supply, the increase in demand results in a shortage and the price of biofuel rises from P1 to P2.