Question

Short Answers

A. Explain in detail the role that prices play in a market economy.


B. What are relative prices, and why are relative prices extremely important to the business manager?

Answer 1

A. Explain in detail the role that prices play in a market economy.

The price of goods plays a crucial role in determining an efficient distribution of resources in a market system.

• Price acts as a signal for shortages and surpluses which help firms and consumers respond to changing market conditions.
• If a good is in shortage – price will tend to rise. Rising prices discourage demand, and encourage firms to try and increase supply.
• If a good is in surplus – price will tend to fall. Falling price encourage people to buy, and cause firms to try and cut back on supply.
• Prices help to redistribute resources from goods with little demand to goods and services which people value more.
• Adam Smith talked about ‘the invisible hand’ of the market. This ‘invisible hand’ relies on the fluctuation of prices to shift resources to where it is needed.

Example of how price influences a market

1. Fall in supply causes higher price

• As the supply of oil falls, the price rises.
• In the short-term, demand is price inelastic and so there is only a small fall in demand.

2. Impact in long-term

However, markets do not stay static. If price rises, the profitability of producing oil increases. Firms can now make super-normal profit because the marginal revenue is greater than marginal cost.

Therefore, this higher price acts as an incentive for firms to try and increase supply. For example, at a low price, it was not worth drilling for oil in the North Sea, but with the higher price, it is an incentive.

Therefore, in the long-term, the higher price causes more investment in the industry and supply can increase back to S LR.

B. What are relative prices, and why are relative prices extremely important to the business manager?

A relative price forsay, is the price of a commodity such as a good or service in terms of another; i.e., the ratio of two prices. A relative price may be expressed in terms of a ratio between any two prices or the ratio between the price of one particular good and a weighted average of all other goods available in the market. A relative price is an opportunity cost. Microeconomics can be seen as the study of how economic agents react to changes in relative prices.

In the demand equation Q = f(P) (in which Q is the number of units of a good or service demanded), P is the relative price of the good or service rather than the nominal price. It is the change in a relative price that prompts a change in demand. For example, if all prices rise by 10% there is no change in any relative prices, so if consumers' nominal income and wealth also go up by 10% leaving realincome and real wealth unchanged, then demand for each good or service will be unaffected. But if the price of a particular good goes up by, say, 2% while the prices of the other goods and services go down enough that the overall price level is unchanged, then the relative price of the particular good has increased while purchasing power has been unaffected, so the demand for the good will go down.

Often inflation makes it difficult for economic agents to immediately distinguish increases in the price of a good which are due to relative price changes from changes in the price which are due to inflation of prices in general. This situation can lead to allocative inefficiency, and is one of the negative effects of inflation.