Question

Question 6

A. Identify two (2) functions of price in the market economy.
B. Explain how price is determined in the market economy.
C. What are the possible results if the government interferes with the price level that the free market has determined? Explain how those results could occur and illustrate with an appropriate supply and demand graph.

Answer 1

a) Two functions of Price are Signalling Function and Rationing function

Signalling function means the price is used as signaling about what goods are needed in the market and what is not. If the price of the goods is high that means the supply of the goods is needed and if the prices are down that means the supply is more and demand is less.

Rationing function: Price rationalize the market when prices are high the people who are not interested in the good at that high price exit the market and if prices are low more and more people come in to buy the products. It acts as a rationalizing factor.

b) In an economy, the price is determined by the forces of supply and demand. The point where the demand is equal to the supply of the goods it becomes the equilibrium price.

c) A government intervention in the market can lead to the supply and demand mismatch which can lead to distortion. After government intervention, the demand can be more or supply can be more. For example, if the government has set a price floor it means no supplier can sell the products at below the cost set by the government this will lead to increase in the supply of goods and decrease in the demand of goods. The graph below shows the effect of a price floor set by the government in the gas market. It is above the equilibrium price of P and at the PF the quantity demanded is Qs and quantity supplied is Q'.