Price Mechanism In Free Markets Flashcards
Define a free market economy.
A free market economy refers to an economy in which the market forces of supply and demand determine how resources are allocated.
What are the main features of a free market economy?
- Private ownership of resources.
- Market forces determining prices.
- Producers aim to maximise profits.
- Consumers aim to maximise satisfaction.
- Resources are allocated by the price mechanism.
What are the advantages of a free market economy?
- Consumer sovereignty i.e. spending decisions by consumers determine what is produced.
- Flexibility, which means that there a quick reactions to changes in consumer wants.
- No officials are needed to allocate resources.
- Profit motives provide an incentive to firms to take risks.
- Competition and the profit motive help to promote an efficient allocation of resources.
- Increased choice for consumers compared to a command economy.
- Economic and political freedom for consumers and producers to own resources.
What are the disadvantages of a free market economy?
- Inequality - those who own resources are likely to become richer than those that don’t.
- Trade cycles - free market economies may suffer from instability in the form of booms and slumps.
- Imperfect information - consumers may not be able to make rational decisions if they have inadequate information or if there is asymmetric information.
- Monopolies - there is a danger that a firm may become the sole supplier of a product and then exploit customers by charging prices higher than the free market equilibrium.
- Externalities - these are costs and benefits not taken into account when goods are consumed and produced.
What two features of a consumer with regard to a product constitute demand?
Demand is the amount of a product consumers are willing and able to buy at each price over a certain period of time.
Why does the demand curve slope downwards from left to right?
As price decreases more of a product will be demanded, so they have an inverse relationship.
What factors can cause a shift in the demand curve?
- An effective advertising campaign.
- A change in the real disposable incomes of consumers.
- A change in the size or age distribution of the population.
- Tastes, fashions or preferences changing.
- Changes in the price of substitute or complimentary goods.
- A change in interest rates (i.e. how easy it is to be loaned money).
Define supply.
Supply refers to how much of a product is supplied at each price over a certain period of time.
Why does the supply curve slope upwards from left to right?
As price increases it becomes more profitable for companies to supply this good and so supply extends.
How is the free market equilibrium arrived at?
The equilibrium (price and quantity) is determined by the interaction of the supply and demand curves. The equilibrium price and quantity would not change unless there is a change in the conditions of supply or demand.
What factors may cause a shift in the supply curve?
Change in the costs of production, such as:
- Changes in productivity.
- Indirect taxes.
- Subsidies.
- Technological improvements.
- Discoveries of new reserves or raw materials.
What are the functions of the price mechanism?
- Rationing - market forces ensure that the amount demanded is exactly equal to the amount supplied.
- Determining changes in wants - a change in demand will be reflected by a change in price.
- Signals producers - producers are alerted to the need to increase or decrease the amount supplied.
- To be an incentive - the prospect of making a profit incentivises firms to produce and supply goods and services.
How does changing prices of a substitute change demand?
Substitues are in competitive demand so a rise in price of a substitute will increase demand for a good, and a decrease in price of a good will lead to a decrease in demand for a good
How does changing prices of a complement change demand?
Complements are in joint demand, so a rise in price of one good causes a fall in demand for in its complement.
How does changing incomes affect demand?
-More disposable income means more demand, for normal goods (Eval: But not for inferior)
