Y1 7) Price Mechanism - The 4 Functions (Signalling, Incentivising, Rationing & Allocating)
Summary
TLDRThis video script explores how the price mechanism functions when demand and supply curves shift. It illustrates the process of equilibrium adjustment through shifts in demand and supply curves to the right. When demand increases, causing a shortage, prices rise, incentivizing firms to produce more. Conversely, when supply increases, leading to a surplus, prices fall, prompting firms to reduce output. Both scenarios demonstrate the market's self-correcting nature and the role of the price mechanism in achieving allocative efficiency.
Takeaways
- đ The video discusses how the price mechanism functions when demand and supply curves shift.
- đ A rightward shift of the demand curve indicates an increase in demand at the initial price (P1).
- đ The initial reaction to increased demand is a shortage, leading to an excess demand and a disequilibrium.
- đč Firms respond to the excess demand by raising prices, which is a natural outcome of the price mechanism.
- đ The price increase from P1 to P2 signals to consumers and producers the need for more resources in the market.
- đ Higher prices incentivize firms to increase output and make more profit, which is shown as an expansion along the supply curve.
- đ Higher prices also discourage consumption, leading to a contraction along the demand curve.
- đ A rightward shift of the supply curve indicates an increase in supply at the initial price (P1).
- đ The initial reaction to increased supply is a surplus, leading to an excess supply and a disequilibrium.
- đč Firms respond to the excess supply by lowering prices, which is another natural outcome of the price mechanism.
- đ The price decrease from P1 to P2 signals to consumers and producers the need for fewer resources in the market.
- đ Lower prices incentivize producers to reduce output or liquidate stocks to increase profit, shown as a contraction along the supply curve.
- đ Lower prices encourage more demand, shown as an expansion along the demand curve.
Q & A
What happens when the demand curve shifts to the right at the initial price level?
-When the demand curve shifts to the right at the initial price level (P1), it creates a disequilibrium in the market, leading to excess demand or a shortage. This happens because the new demand (QD) is greater than the current supply (Q1).
How do firms respond to excess demand in the market?
-Firms respond to excess demand by raising prices. As customers compete to buy the good or service, firms see an opportunity to increase prices, which helps move the market towards a new equilibrium.
What role does the incentive function play when prices rise due to excess demand?
-The incentive function motivates firms to increase their output when prices rise. Higher prices signal firms to produce more as they can sell more units at a higher price, thus increasing profitability.
How is excess supply (or surplus) created when the supply curve shifts to the right?
-Excess supply occurs when the supply curve shifts to the right at the initial price level (P1). This shift increases the supply to Qs, while the demand remains at Q1. The result is a surplus, where the supply is greater than the demand at P1.
What is the outcome when prices fall due to excess supply in the market?
-When prices fall due to excess supply, it signals producers to reduce output and liquidate existing stocks. Lower prices also incentivize more demand from consumers, helping the market move back to equilibrium.
How does the price mechanism help restore equilibrium when there is excess supply?
-The price mechanism restores equilibrium by reducing prices, which signals to producers to decrease output and to consumers to increase demand. These actions continue until the market reaches a new equilibrium at a lower price and higher quantity level (Q2).
What is allocative efficiency, and how is it achieved in this context?
-Allocative efficiency is achieved when the quantity supplied matches the quantity demanded, ensuring that resources are optimally allocated in the market. It is achieved when the market corrects itself through changes in prices, leading to a new equilibrium.
What are some of the non-price factors that can shift the demand curve?
-Non-price factors that can shift the demand curve include changes in consumer preferences, income, population size, expectations, and the prices of related goods (substitutes and complements).
What is the primary function of the price mechanism in the market?
-The primary function of the price mechanism is to balance supply and demand by signaling, incentivizing, and rationing resources, which ultimately leads to market equilibrium.
What is the significance of understanding shifts in demand and supply curves for economic analysis?
-Understanding shifts in demand and supply curves is crucial for economic analysis because it helps identify how external factors affect market equilibrium, how prices and quantities adjust, and how resources are reallocated in response to changes in the market.
Outlines
đ Understanding Shifts in Demand and Supply
This paragraph discusses how the price mechanism functions when demand and supply curves shift. It begins with a demand curve shifting to the right due to non-price factors, creating a disequilibrium at the initial price P1. The new demand is at QD, exceeding the supply at q1, resulting in excess demand or a shortage. The market corrects this through price increases, which incentivize firms to increase output and ration resources by discouraging consumption. The outcome is a new equilibrium at a higher quantity and price, Q2, achieved through the price mechanism's functions of signaling excess demand, incentivizing output increase, and rationing resources.
đ Effects of Supply Shifts on Market Equilibrium
The second paragraph examines the impact of a supply curve shifting to the right, also due to non-price factors, leading to an excess supply or surplus at the initial price P1. The market self-corrects by lowering prices, signaling an excess supply and the need for fewer resources. Producers respond by reducing output or leaving the market, which is shown as a contraction along the supply curve. Lower prices also encourage more demand, expanding the demand curve. Combining these effects, the market reaches a new equilibrium at quantity Q2, demonstrating allocative efficiency. The paragraph concludes by encouraging viewers to apply this understanding to shifts in demand and supply to the left, as an exercise to solidify their grasp of market dynamics.
Mindmap
Keywords
đĄPrice Mechanism
đĄDemand Curve
đĄSupply Curve
đĄDisequilibrium
đĄExcess Demand
đĄExcess Supply
đĄAllocative Efficiency
đĄIncentive Function
đĄShift
đĄEquilibrium
đĄNon-Price Factors
Highlights
Introduction to the functions of the price mechanism, applying them to shifts in demand and supply curves.
Explanation of the non-price factors that cause the demand curve to shift to the right, leading to excess demand.
Illustration of the disequilibrium created when demand shifts right at the initial market price, showing excess demand or shortage.
Analysis of how firms respond to excess demand, with customers bidding up prices, leading to price increases.
Description of the price rise from P1 to P2, with multiple rises in reality, showing how market forces correct disequilibrium.
The role of higher prices in signaling excess demand and incentivizing firms to increase output by utilizing resources efficiently.
Introduction of the expansion along the supply curve, where new firms may enter the market or existing firms increase production.
Discussion of how higher prices ration scarce resources by discouraging consumption, leading to a contraction along the demand curve.
Explanation of how the market reaches allocative efficiency at a new equilibrium (Q2), with higher prices and higher quantity.
Application of the same principles to a rightward shift in the supply curve, creating excess supply and a surplus.
Firms' response to excess supply, with full warehouses and excess stock, leading to falling prices.
Description of the price fall from P1 to P2, driven by excess supply and market pressure.
Lower prices signal excess supply, leading producers to reduce output and liquidate stocks, shown via a contraction along the supply curve.
Lower prices incentivize firms to leave the market or reduce production, while also encouraging more demand, shown by an extension along the demand curve.
Final explanation of how the market reaches a new equilibrium (Q2) after a rightward shift in supply, achieving allocative efficiency once again.
Transcripts
hi everyone so from my previous video
we've understood what the functions of
the price mechanism are and how they
work in this video we want to apply
those same functions to when demand and
supply curve shift let's start by
looking at a demand curve shifting to
the right now we know what all the
factors are that can do this we've
learned them as specific factors but
when we covered those factors we said
they're all non-price factors that shift
the demand curve meaning when this
demand curve is Shifting to the right
it's shifting at the initial price in
the market which in this case is P1 so
our job always when a curve is Shifting
is to find the disequilibrium which will
always exist when a curve is shifted so
in this case demand is shifted right but
it's shifted at the initial price of P1
so extend P1 across to find the new
demand which is all the way over here
call it QD where supply has remained at
q1 so demand is greater than Supply this
is an excess demand this is a shortage
that's the disequilibrium once you've
found that should be easy to understand
how the functions of the market will
take this away will correct this problem
because we covered that in my previous
video but let's do it again so in
reality firms are going to be seeing
large cues of people desperate to buy
this good or service they'll be long
waiting lists of people desperate to buy
this good or service there could be
competition between buyers right so it's
clear firms are not able to supply the
demand that's out there but also firms
are seeing customers consumers who are
bidding up their prices they are so
desperate to buy this good or service so
naturally what happens with prices
prices rise
we learned in my previous video that
access Divan puts upward pressure on
prices so on our diagram let's say the
price rise is perfect
from P1 to P2 in reality this will be
numerous price Rises before we get to P2
but let's keep things simple and just go
straight to P2 here at which point bam
the functions of the price mechanism
kick in we know that now at higher
prices just think RC RC yes those
functions kick into gear yes what
happens first well higher prices signal
the fact that there has been excess
demand for both consumers and producers
but also higher prices signal the need
now for more more resources in this
market higher prices incentivized firms
to increase their output to make more
profit of course now produce more you
can sell more at a higher price what a
way to make more profit we can show that
function via an expansion along the
supply curve or an extension along the
supply curve so this could be new firms
entering the market this could be
existing firms increasing output by
investing in new capacity or using up
spare capacity but there we go that is
the incentive function
higher prices also ration scarce
resources in this case by discouraging
consumption we can show that via a
contraction along the demand curve put
those last two effects together where do
we end up we end up with quantity Q2
which is at equilibrium which we know is
allocative efficiency awesome awesome
right so we've achieved allocative
efficiency we've achieved equilibrium
the reallocation of resources is now
with a higher quantity at higher prices
that's how markets work when we have an
increase in demand demand shifting right
how do we get from P1 q1 to a new
equilibrium all sorted thanks to RC
let's do the same thing for a supply
shift to the right once more we know
what all these factors are we've learned
them as pints WC factors and again these
are all non-price factors so like before
when the supply curve shifts it will
shift at the initial price in the market
in this case P1 we need to find the
disequilibrium once we find that we can
rock it forward from there so with the
supply shift to the right that's
happened at P1 extend that price line
across to get the supply which is now
over here at Qs the demand has remained
at q1 Supply is greater than demand this
is an excess Supply this is a surplus at
this point again we should know how this
is going to be self-corrected but let's
go through it to make sure there's full
proof understanding so what a firm is
going to be seeing with an excess Supply
with a surplus their warehouses are
going to be full of stock physical
stores are going to be full of stock on
the shelves if you're a restaurant your
tables are empty your kitchen is full of
ingredients right at which point prices
naturally fall yes covered that in the
last video didn't we and we know that
excess Supply surpluses put downward
pressure on prices again let's say it's
a perfect price for from P1 to P2 in
reality it will be numerous price drops
before we get to P2 but let's keep
things simple here at which point bam RC
the functions of the price mechanism
kick in yes they do and that's how we
can end up at this new equilibrium what
happens first well lower prices first
signal signal that there has been an
excess Supply to both consumers and
producers but they also signal the need
for fewer resources less resources in
this market lower prices incentivize
producers to reduce output instead
liquidate stocks sell your stocks that's
the way to increase profit by cutting
output and liquidating stocks we can
show that effect via a contraction
along the supply curve so what's
happening here
this could be firms leaving the market
or existing firm's cutting capacity
reducing output that way that's the
incentive function at the same time
lower prices ration scarce resources in
this case by encouraging more demand the
expansion or the extension along the
demand curve shows that effect put those
last two effects together where we ended
up We've Ended up at a new quantity
Q2 wonderful this is at equilibrium we
know equilibrium is allocative
efficiencies like magic row these
functions of the price mechanism are
magical things absolutely lo and behold
equilibrium allocative efficiency excess
Supply completely taken away incredible
to see this in reality like this we've
done it the functions of the price
mechanism how they work in getting from
one equilibrium to a new equilibrium
we've done it for a demand shift to the
right and a supply shift to the right
there are two shifts left though aren't
there demand shifting left Supply
shifting left I'm going to leave that to
you guys what a nice exercise for you to
do to see whether you really get it it
should be very simple because there are
only two disequilibrium aren't there an
excess demand or an excess Supply we've
covered both here you just have to find
that and go forward use this video use
the previous video to make sure you can
get that nailed on but that is
fascinating stuff you might say magical
stuff for you guys seeing markets in
action thank you so much for watching
can't wait to see you all in the next
video
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