The workings/functions of the price mechanism

In a free market, the price of goods and services are determined by the forces of demand and supply. Which means the interactions of buyers and sellers determine the price of goods and services in a market.  Determining and changes in the price through price mechanism  can allocate resources. Resources move towards where they are in the shortest supply in comparison to demand, and away from where they are least demanded.

Price mechanism – The rationing function

Rationing means distributing the resource that is in shortage among those who are in need for it, even though each person may not get as much as he wants. In case of price mechanism, when a particular resource is in shortage, the excess demand over supply will drive up the prices, which will decrease the quantity demanded of that resource and the system has a rationing effect, as well as a conserving effect.

rationing-effect

Price Mechanism – The Signalling function

Price changes send contrasting messages to consumers and producers about whether to enter or leave a market. Rising prices signals to consumers to reduce demand or withdraw from a market completely, and they give a signal to the existing producers to increase production or to potential producers to enter a market. On the other hand, falling prices signals to consumers to enter a market while sending a negative signal to producers to leave a market. For example, a rise in the market price of smartphones sends a signal to potential manufacturers to enter this market, and perhaps leave another one. Similarly, the provision of ‘free’ healthcare may signal to ‘consumers’ that they can pay a visit to their doctor for any minor ailment, while potential private healthcare providers will be discouraged from entering the market. In terms of the labour market, a rise in the wage rate provides a signal to the unemployed to join the labour market.

Price Mechanism – The Incentive function

An incentive is something that motivates a producer or consumer to follow a course of action or to change behaviour. Higher prices provide an incentive to existing producers to supply more because they provide the possibility or more revenue and increased profits. The incentive function of a price rise is associated with an extension of supply along the existing supply curve.

Social costs and benefits; cost-benefit analysis

COST-BENEFIT ANALYSIS

Social Costs and benefits

Every business activity which takes place has some benefits and costs attached to it. The benefits go both to the owners of the firm as well as to external stakeholders. In the same way the owners and the external stakeholders have to pay a cost for the activities of the business.
Social cost:-

Social cost is the sum of private cost and external cost. For example, the manufacturing cost of a car (i.e., the costs of buying inputs, land tax rates for the car plant, overhead costs of running the plant and labor costs) reflects the private cost for the manufacturer. Water or air is also polluted as part of the process of producing the car, This is an external cost borne by those who are affected by the pollution or who value unpolluted air or water. Because the manufacturer does not pay for this external cost, and does not include this cost in the price of the car. The air pollution from driving the car is also an externality produced by the car user in the process of using his good. The driver does not compensate for the environmental damage caused by using the car.

Social-Cost is the cost to an entire society resulting from an event, an activity or a change in policy. Social cost equals the sum of private cost and external cost.

When assessing the overall impact of its commercial actions in terms of social costs, a socially responsible business operator should take into account its own production expenses, as well as any indirect expenses or damages borne by others.

  • Private cost:-

It is the cost of setting up the business. The owner(s) pay for the hire of machinery, buying of materials, payments of wages. This is termed as Private Cost.

  • External Cost:-

The problems that the external stakeholders have to bear due to the firm’s activity are known as external cost. Example: cleaning a river which has been polluted by a firm’s waste products. Private firms usually ignore external cost.

Social benefits:-

Social benefits are the sum of private benefits and external benefits. For example, a college decides to slash its tuition rates by half. This encourages more people to get educated. A better-educated workforce, in turn, helps businesses produce more. Thus, even though the businesses did not pay for the reduced college tuition, they still reap a positive external benefit from the college’s move. The increase in the welfare of a society that is derived from a particular course of action. Some social benefits, such as greater social justice, cannot easily be quantified.

Social benefits is the sum of private benefits and external benefits

  • Private benefit:-

The benefit enjoyed by those involved in the production or consumption . For example, the revenue earned by the firm is a benefit for the owner and is termed as Private benefit.

  • External benefits:-

Some firms can cause external benefits. These are the benefits to the external stakeholders due to the activity of firm. For example, a firm may train workers, which might get them better wages in other firms. These external benefits are free.

 

Use of cost benefit analysis in decision making

Most of us are familiar with the term ‘cost-benefit analysis’ and have a basic grasp of it. It refers to how a project or decision might be evaluated, comparing its costs with its benefits. In many cases, it’s a like a quantified pros-and-cons list… It’s an analysis of the expected balance of benefits and costs… Cost-benefit analysis sometimes called ‘benefit–cost analysis’ is a systematic process for calculating and comparing benefits and costs of a project, decision, government policy… CBA has two purposes:

  1. Determine if it’s a sound investment/decision (justification/feasibility).
  2. Provide a basis for comparing investments, decisions, projects… It involves comparing the total expected cost of each option against the total expected benefits, to see whether the benefits outweigh the costs and by how much…

According to Nicole Gordon; cost-benefit analysis is used to decide if the cost of a solution and the economic benefits that would result from it are worth the risk. The main idea behind this strategy is that the benefits must exceed costs to justify the policy…

When performing a cost-benefit analysis, you make a comparative assessment of all the benefits you anticipate from your project and all the costs to introduce the project, perform it, and support the changes resulting from it. Cost-benefit analyses help you to:

  • Decide whether to undertake a project or decide which of several projects to undertake.
  • Frame appropriate project objectives.
  • Develop appropriate before and after measures of project success.
  • Prepare estimates of the resources required to perform the project work.
  • Everything gets a dollar value in a cost-benefit analysis.

There are some advantages and disadvantages of cost and benefit analysis.

Advantages:-

  • The main advantage of cost benefit analysis is its simplicity. You are simply looking at whether benefits outweigh costs. When you do this quantitatively, measuring the dollar amount of the benefits and the costs involved in a project, the cost benefit is very easy to see.

Disadvantage:-

  • The simplicity of cost benefit analysis can paradoxically lead to complications; to gain this simplicity, you have to use a common measurement– one of the disadvantages of CBA. Determining the quantitative benefits of a project is relatively straightforward; you basically add up the costs and benefits and compare the two. However, when you factor in qualitative benefits, the picture can become more complicated.

Example:-

You are considering implementing an employee bonus program, you will obviously incur costs. In exchange, you may receive benefits like increased employee satisfaction, decreased turnover and greater productivity. The benefits are significant but difficult to compare– apples to apples– to the costs involved… A frequently made mistake is the use of non-discounted amounts for calculating the costs and benefits; typically the cost is tangible– hard and financial– while the benefits are hard and tangible, but also soft and intangible.

Written by Tehmina Khan

Externalities and Market Failure

Reasons for market failure

Market Failure occurs when there is an inefficient allocation of resources in a free market. This may occur due to:

Types of market failure:

  1. Positive externalities – Goods / services which give benefit to a third party, e.g. a bee keeper’s bees can pollinate nearby crop fields. Even though this is a good thing, the market system fails to account for the benefit arising from it.
  2. Negative externalities – Goods / services which impose cost on a third party, e.g. smoking causes cancer to those who don’t smoke as well (through passive smoking).
  3. Merit goods – People underestimate the benefit of a particular good, e.g. education. Therefore they under-consume it. Without the government encouragement, the people under-consume such goods.
  4. Demerit goods – People underestimate the costs of good, e.g. smoking. Even with so much campaigns against smoking, people still continue to smoke.
  5. Markets fail to provide public Goods – Goods which are non-rival and non-excludable – e.g. police, national defense. The market simply fails to provide them.
  6. Monopoly Power – when a single firm controls the market they can set higher prices and exploit the consumers.
  7. Inequality – unfair distribution of resources in free market
  8. Factor Immobility – E.g. geographical / occupational immobility
  9. Imperfect and asymmetrical information – where there is no enough information to make an informed choice.

Externalities

A consequence of an economic activity that is experienced by unrelated third party. An externality is the cost or benefit that affects a party who did not choose to incur that cost or benefit.

Types of externalities:-

There are two types of externality.

  • Positive externality
  • Negative externality

Positive externality:-

A positive externality is a benefit that is enjoyed by a third party as a result of an economic transaction. Third parties include any individual, organization, property owner, or resource that is directly affected. While individuals who benefit from positive externality without paying are called to be free rider. Government can play a role in encouraging positive externalities by providing subsidies for gods or services that generates spillover benefits. Such subsidies provide an incentive for firms to increase the production of goods that provide positive externalities. And, because the spillover benefits goes to society, government subsidies are a way for society to share in the cost of generating positive externalities.

Examples:-

  • When you complete high school, you’ll reap the benefits of your education in the form of better job opportunities, higher productivity, and higher income. A technical degree or college education will further enhance those benefits. Although you might think you are the only one who benefits from your education, that isn’t the case. The many benefits of your education spill over to society in general. In other words, you can generate positive externalities. For example, a well-educated society is more likely to make good decisions when electing leaders. Also, regions with a more-educated population tend to have lower crime rates. In addition, more education leads to higher worker productivity and higher living standards for society in general.
  • Social benefits from the maintenance of a post- officenetwork.
  • A new motorway or road improvement scheme generates third party benefits including reduced transport cost for local firms and generates a regional multiplier effect.

 

Negative externality:-

A negative externality occurs when an individual or firm making a decision does not have to pay the full cost of the decision. If a good has a negative externality, then the cost to society is greater than the cost consumer is paying for it. Since consumers make a decision based on where their marginal cost equals their marginal benefit, and since they don’t take into account the cost of the negative externality, negative externalities result in market individual inefficiencies unless proper action is taken. Negative externality is a cost that is suffered by third party.third parties include any, organization, property owner, or resource that is indirectly affected.

Examples of negative externalities:-

  • A common example of a negative externality is pollution. For example, a steel producing firm might pump pollutants into the air. While the firm has to pay for electricity, materials, etc., the individuals living around the factory will pay for the pollution since it will cause them to have higher medical expenses, poorer quality of life, reduced aestetic appeal of the air, etc. Thus the production of steel by the firm has a negative cost to the people surrounding the factory–a cost that the steel firm doesn’t have to pay.
  • If you play loud music at night your neighbour may not be able to sleep.
  • If you produce chemicals and cause pollution as a side effect, then local fishermen will not be able to catch fish. This loss of income will be the negative externality.
  • If you drive a car, it creates air pollution and contributes to congestion. These are both external costs imposed on other people who live in the city.
  • If you build a new road, the external cost is the loss of a beautiful landscape which people can no longer enjoy.

 

externalities

Tehmina Khan contributed to this tutorial

New Tutorial Added: Joint demand and alternative demand

Joint demand means two or more goods are demanded together. To consume one good, you need another good. In other words they are complements. For example, if the demand for tea increases, the demand for sugar will also increase. Here tea and sugar are complements.

Another good example of joint demand is, printers and ink cartridges. You might have noticed that some models of printers with very high functionality are sold at a very cheap price. You may think that the printers are of lower quality or produced with cheap labour.

Read the full article

Joint demand and alternative demand

Joint demand means two or more goods are demanded together. To consume one good, you need another good. In other words they are complements. For example, if the demand for tea increases, the demand for sugar will also increase. Here tea and sugar are complements.

Another good example of joint demand is, printers and ink cartridges. You might have noticed that some models of printers with very high functionality are sold at a very cheap price. You may think that the printers are of lower quality or produced with cheap labour. In fact, it may not be the case. Those printers are usually sold at a loss. The profit is made from the sale of ink that has to be used with the printer. The cheap price of the printer is a lure for people to buy the printer.

Alternative demand: Alternative demand is derived from the changes in the price of substitutes. When the price of a good goes down, people who have been using other goods with similar or exact same use (substitutes) may move to buying that particular good. In this case, the demand came from people who had been using alternative goods. This will also happen if the price of substitute goods increases.

Price of substitute goods is a determinant of demand.

Students may get confused between the concept of derived demand and joint demand. Watch this video to get a good explanation.

Tutorial Added: Equilibrium and Disequilibrium in the market

Shortage and SurplusThe word equilibrium means at rest. Equilibrium in the market is the combination of price and quantity from which there is no tendency for buyers or sellers to move away. In a graphical representation, equilibrium means the intersection point of the supply and the demand curves.

Equilibrium Price or Market Clearing Price is the price at which the quantity demanded of a good equals the quantity supplied.

Read More

Equilibrium and Disequilibrium in the market

The word equilibrium means at rest. Equilibrium in the market is the combination of price and quantity from which there is no tendency for buyers or sellers to move away. In a graphical representation, equilibrium means the intersection point of the supply and the demand curves.

Equilibrium Price or Market Clearing Price is the price at which the quantity demanded of a good equals the quantity supplied.

Equilibrium Quantity is the quantity that corresponds to the equilibrium price. This is the quantity at which the amount of the good that buyers are willing and able to buy equals the amount that sellers are willing and able to sell, and both equal the amount actually bought and sold.

Equilibirum in the market
Demand & Supply of Compact Discs – P* is the equilibrium price and Q* is the equilibrium quantity

Disequilibirum in the market arises at any price at which the quantity demanded is not equal to the quantity supplied. In other words, this is a situation of either a surplus or shortage in the market.

If the quantity supplied is greater than the quantity demanded, it is termed as a surplus or excess supply.

If the quantity demanded is greater than the quantity supplied, it is known as a shortage or excess demand.

What happens when there is a shortage or a surplus?

Shortage and Surplus

The situation of surplus

When we look at this diagram, we can see that there is a surplus at a price of $15: the quantity supplied is 150 units where as the quantity demanded is 50 units. Suppliers will not be able to sell all they had hoped to sell at $15. As a result their stock of goods will grow above the level they usually hold in preparation for the demand changes. If the sellers want to reduce this stockpile of goods, either they have to reduce the price or cut back on production or they could do both. Therefore there will be a tendency for price and the output to fall until the equilibrium is achieved. This is shown in the diagram with the downward arrows.

The situation of shortage

At the price of $5, there is a shortage. Quantity demanded is greater than the quantity supplied. Buyers will not be able to buy all that they hoped to buy at $5. Some buyers will offer to buy at higher prices so that the sellers would sell to them rather than to the other buyers. When the sellers realize this, they will raise the prices to get more profit, and also they will try to increase output since it is profitable to do so. This tendency for the price and output to increase will continue until the equilibrium is achieved.

Price Elasticity of Supply

Price elasticity of supply is a measure of the sensitivity (responsiveness) of the quantity supplied of a good or service to a change in the price of that good or service.

% Change in Quantity Supplied
Price Elasticity of Supply =
% Change in Price

If the price of a good or service increases in the market, the suppliers/producers will naturally tried to increase their supply, so that they can make more profit. However, there will be limits by which they can increase the output. Price elasticity of supply measures this ability of them to increase the output.

Calculation of price elasticity of Supply

Suppose that the price of a good increases from $10 to $12, and in response to this increase in price, the firms increase the quantity supplied from 2000 units to 2200 units. let us calculate the price elasticity of supply.

% Change in Quantity Supplied = 100 X 200/2000 = 10%.

% Change in Price = 100 X 2/10 = 20%

Price Elasticity of Supply = 10/20 = 0.5.

If the calculation of this formula shows a number which is greater than 1, then the supply is price elastic.

If it is less than 1, then the supply is price inelastic.

Unit elasticity occurs where PES = 1.

The interpretation of the elasticity is straight forward. If the PES is 0.7, an increase in price of 10% will lead to an increase in the quantity supplied of 7%, which means it is inelastic.

If the PES is 1, an increase in price of 10% will lead to an increase in the quantity supplied of 10%.

Elasticity of Supply – Demand & Supply diagrams

Price Elastic Supply


Price inelastic supply


Unitary Price Elasticity of Supply


Infinitely price elastic Supply

Factors affecting elasticity of supply

Time:Firms may not be able to respond quickly to a sudden change in price. However, as time goes, they will be able to increase production. It is feasible for firms to change their supply decision in the long run than in the short run. In the short-run there will be fixed costs, and the firm can increase production only by increasing variable inputs like labour. However, in the long-run the firm can invest in machinery and other factor inputs, which give them more capacity, and thus supply tends to be more price elastic in the long-run.

Availability of resources / Spare Capacity: If the economy is already using most of its scarce resources, then firms will find it difficult to employ more (i.e. workers) and so the firms will not be able to increase output. In such a situation, the supply of most goods and services will be price inelastic, and vice versa.

Number of producers: If there are more producers in the economy, the possibility of increasing the aggregate output is higher. Therefore, supply tends to be price elastic when the number of producers are high.

Ease of storing stocks: The type of good that a producer supplies will affect elasticity. If goods can be stocked with ease and have a long shelf life, then supply will be elastic. Otherwise the goods will be inelastic. For example, perishable goods such as fresh flowers, vegetables have comparatively inelastic supply because it is difficult to store them for longer periods.

Increase in cost of production as compared to output (marginal cost): In cases where there is a significant increase in cost of production when output is increased, supply is inelastic. As the marginal cost keeps on rising at higher production levels, the producers will be hesitant to increase output, especially if the marginal cost is higher than the price levels (marginal revenue).

Improvements in Technology: Some industries will have improvements in technology that affects the price elasticity of supply. Improvements lead to goods being more elastic (i.e. firms are more efficient in production- better machinery. so output can be easily increased when there is an increase in price.

Stock availability of finished goods: In some industries where there are higher inventory or stock of finished goods, the suppliers can supply more as the price rises. Thus, the price elasticity of supply for these goods will be elastic.

Tutorial Added – Classification of goods and services

Goods and services can be classified into various categories based on their nature of scarcity.

Free Goods

A free good is available in abundance to people. Consumption of a free good does not arise in an opportunity cost.
Examples of free goods are air, water etc. Sometimes, a good maybe a free good in one country where as it may become an economic good in another country in which the consumers have to pay to use it.

Read More…

Classification of goods and services

Goods and services can be classified into various categories based on their nature of scarcity.

Free Goods

A free good is available in abundance to people. Consumption of a free good does not arise in an opportunity cost.
Examples of free goods are air, water etc. Sometimes, a good maybe a free good in one country where as it may become an economic good in another country in which the consumers have to pay to use it.

Sometimes a good may be given away free of charge, but it still may not be a free good if the production and the use of that good involves opportunity cost. For example, free gifts given away in promotions by companies. Sometimes a consumer may not have to pay for a good because it is already paid by the taxes, in that case it still involves opportunity cost, and therefore it is not a free good.

Private Goods (Economic Goods)

A private good or an economic good is a good which is scarce and the consumer has to pay a price to get that good. Most of the goods which satisfies human wants are economic goods. Anything that has money value, and anything that is scarce, and which satisfies human wants is an economic good.

Public Goods

There certain goods and services which cannot be produced by the private sector (which is driven by the profit motive. For the private sector to supply something, the consumers need to be charged so that the costs can be covered and the profit achieved.
The use of these cannot be charged from the consumer because the consumer who refuses to pay cannot be excluded from using the good or service. Once provided, everyone can use the good. This is known as non-excludability. There is also non-rivalry in consumption of such goods. One person consuming the good does not reduce the amount available for others to consume the same good.

Merit Goods

A good where people underestimate the benefits of consuming. Merit goods usually have positive externalities. These are the goods, the consumption of which, are good for the society as a whole.

These goods maybe under consumed because of the lack of information. In the same way, people maybe consuming demerit goods because they don’t know that those goods are not so beneficial to the society and even to them.

Eg. Education is a merit good. People underestimate benefits of studying and so there is under-consumption.

Merit goods may be provided in a free market – but in insufficient quantities.

Merit good should not be confused with ‘public goods’. Merit goods do not have the characteristics of non-rivalry and non-excludability.

Demerit goods

Demerit goods are the opposite of merit goods. A demerit good is defined as a good which can have negative effects on the consumer – but these damaging effects may be unknown or ignored by the consumer. Demerit goods usually have negative externalities – where consumption of them causes harmful effect to a third party or to the society as a whole. Cigarette, other tobacco products, alcohol and narcotic drugs are examples of demerit goods.