Price System Functions In A Free Market Overall economy Economics Essay

Question 1

Explain how the price mechanism functions in a free market economy in order to solve the essential economics issue of scarcity.

The idea of scarcity in Economics is based on the fact that the individuals dreams are infinite and insatiable and these dreams exceed the production of variety of products because of limited resources. The needs of businesses, government authorities and individuals are never satisfied. Usually the products either deprecate or become obsolete with time and there is a need to replace them. It is argued that state of being insatiable is basic human aspect. Some say that adverts are an important factor in producing new needs. This lust isn't just limited to new products or services but also to personal life like dependence on luxury etc. (Arnold, 2001)

Resources are fewer in quantity but the demands are infinite. Price system determines the source allocation in a free of charge market financial system. Dreams of consumers are unlimited but the resources are limited. That's the reason there's a need to balance the allocation of the resources. Usually prices is used to determine the allocation of resources in contending uses. Any fluctuation in the demand will lead to a fluctuation in supply. Price is utilized as an indicator. Obviously an elevated demand will bring about scarcity of the product which will boost the price. The way to obtain the products is risen to meet up with the needs of the marketplace. Also this will bring about an increase in revenue for the companies. Similarly the reduction in demand will bring about a reduction in supply. The reduction in demand of a product will result in decrease in the profit margin earned during that specific product. So producers decrease the way to obtain that product and make use of the resources in development of other products that will be more in demand. (Krugman, 2009)

Figure 1relationship between demand and price

Pricing method is considered advantageous as it allows the allocation of resources more efficiently. This brings about specialized efficiency as the merchandise are produced at the lowest unit cost. The providers want to produce the merchandise at the nominal costs in the competitive market. The chances of gaining some profit encourage the providers to lessen costs, introduce new products and raise the production of the current products. It is expected that over time this occurrence will cause production of products at most affordable device cost and allocation of resources will be maximum. (Forstater, 2007)

Figure 2 A fluctuation in demand influences price as well

Allocative efficiency is also modified by the marketplaces. The demand can determine the production or supply of the product. Just as the figure above, it can be seen that the increased demand increases the price and a reduced demand decreases the purchase price. Prices are being used as indicators to determine where in fact the highest learning resource allocation is required (usually the merchandise that provide highest earnings). This creates a distinctive balance and makes the reference allocation good for everyone. This can be understood by the example of production of laptop computers. In case the demand for laptop increases, laptop manufacturers increase their productions as the manufacturers of desktop will lower their development. The development will be based on the demand curve of the market. Which means that the production of most sought products is increased. Also, the market changes the changes popular with the change in resource so that there surely is no scarcity of any product. (Gwartney, 2005)

Question 2

Using diagrams discuss any three types of elasticity with that you are familiar. Explain why they are essential.

Curve's elasticity can be defined as the level to which resource or demand curve responds to fluctuation in cost. Elasticity of different products is different as a result of difference in the demand of the merchandise on the market. Essential products like food and clothing are immune to price changes because of the fact that customers will still get them no matter price hikes. The products are believed inelastic. Alternatively if the price tag on a good product or service that's not essential element of day to day life raises, its use will lower. Such products, whose demand or source changes with the change in cost are highly flexible, . (Arnold, 2001)

Elasticity can be computed utilizing the equation

Considering the above mentioned formula, if elasticity of the curve is minimal than one; it denotes that the curve is inelastic. If it is equal to or more than one, it denotes that the curve is elastic. (Forstater, 2007)

The slope of curve of demand is negative. If hook increase in the price tag on a product leads to a huge reduction in the demand, this will cause a flatter or horizontal demand curve. The flatter curve denotes that the specific service or product is highly elastic.

Figure 3 Elastic Demand

On the other palm an upright or just a bit vertical curve is used to depict an inelastic demand.

Figure 4 Inelastic Demand

Similarly for supply, for elastic product or service the curve is level or horizontal. Flatter curve shows that elasticity is greater than or equal to one.

Figure 5 Elastic Supply

For resource, inelastic curve is displayed by an upright or almost vertical curve.

Figure 6 Inelastic Supply

A. Factors Impacting on Demand Elasticity

Demand's price elasticity is afflicted by the next three factors: (Forstater, 2007)

1. The option of substitutes - If there are alternatives for a service or product, of course its demand will be more elastic. This means that even a slight increase in the price tag on something should lead to a decrease in demand of this product. Let's take a scenario of caffeinated drinks. When there is a cost hike of say 50 cents for one sit down elsewhere. It can be substituted with a glass of tea. This makes coffee an stretchy good. Alternatively if the purchase price hike is of caffeine (main component of tea and caffeine) rather than of the product, it will bring about little or decrease in demand of caffeinated beverages (coffee or tea). As, there are no other alternatives for level of caffeine, this makes level of caffeine an inelastic products. If a product is unique so this means having no alternatives, it is considered inelastic.

2. Amount of income open to spend on the good - Demand elasticity is highly dependent on the amount an individual can spend on a certain service or product. This means that if the income of an person will not increase however the price of a product rises, the demand of this product will decrease. When the income is stable, then your demand of the merchandise will become stretchy.

3. Time - Time is also a significant factor that considerably impacts the demand elasticity. If there is an increase in price of product say a can of ale. And the buyer finds out he cannot manage to buy 2 or 3 3 cans of ale at that price in one day. He will reduce the utilization of beer.

B. Income Elasticity of Demand

The second factor mentioned previously claims that if income will stay the same but the price of the merchandise increases, it will result in a decrease in demand. Alternatively upsurge in income will lead to upsurge in demand. So income elasticity of demand can be explained as the level to that your upsurge in income will bring about heightened demand of the product. Following equation shows the income elasticity of demand

ED = Elasticity of Demand

Q = Quantity; Y = Income; EDy = Income Elasticity of Demand

Demand of something has high income elasticity if EDy is more than one. Demand is known as income inelastic if EDy is reduced than 0 (Arnold, 2001)

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