The document discusses the main functions of the price mechanism, which are to allocate scarce resources, ration goods when demand exceeds supply, send signals to producers and consumers about market conditions, and provide incentives. It provides examples of how prices change to perform these functions in markets for goods like food, housing, and cotton. The document also examines factors that can cause price volatility, like shifts in supply and demand, and how elasticity influences the impact of these shifts on price and quantity.

1. The
Price
Mechanism
EdExcel
Economics
1.2.7

2. Main
Func0ons
of
the
Price
Mechanism
1. Allocate
–
alloca3ng
scarce
resources
among
compe3ng
uses
2. Ra0oning
–
prices
serve
to
ra3on
scarce
resources
when
market
demand
outstrips
supply
3. Signalling
–
prices
adjust
to
demonstrate
where
resources
are
required,
and
where
they
are
not
4. Incen0ves
–
e.g.
when
the
price
of
a
product
rises,
quan3ty
supplied
increases
as
businesses
respond!
Prices
send
important
signals
Prices
change
incen3ves
for
consumers
and
suppliers
In
an
economy
like
the
UK,
many
decisions
on
how
to
resolve
the
issues
of
opportunity
cost
and
trade-­‐offs
are
resolved
by
prices.

3. The
Ra0oning
Func0on
The
ra0oning
func0on
-­‐
when
there
is
a
shortage
of
a
product,
price
will
rise
and
deter
some
consumers
from
buying
the
product
Higher
food
prices
Rising
cost
of
ren3ng
Online
auc3ons
Tickets
for
major
event
D1
P1
Price
Quan3ty
S1
S2
P2
In
recent
years
the
steep
rise
in
food
prices
plus
declining
real
incomes
has
highlighted
the
ra3oning
func3on
of
the
price
mechanism

4. The
Signalling
Func0on
The
signalling
func0on
-­‐
changes
in
price
provides
informa0on
to
both
producers
and
consumers
about
changes
in
market
condi3ons
Coffee
farmers
Shale
oil
and
gas
Share
prices
send
signals
Interest
rates
on
loans
“CoEon
farmers
hit
hard
as
prices
drop
to
lowest
since
2009”
(December
2014)
Plen3ful
global
supplies
of
coRon
thanks
to
favourable
weather
have
caused
coRon
prices
to
fall
to
a
5
year
low.
China’s
farmers
benefited
from
a
$5bn
scheme
which
ran
from
2011-­‐14
where
the
government
purchased
coRon
at
a
minimum
price,
building
up
a
huge
stockpile
—
China’s
reserves
have
risen
six-­‐fold
since
2010
and
it
holds
60%
of
the
world’s
coRon
inventories.
The
slump
in
prices
is
being
badly
felt
by
growers
in
the
southern
African
country
Zambia
whose
coRon
industry
employs
a
fi^h
of
the
popula3on.
Consider
the
price
signals
in
this
example

5. Causes
of
Price
Vola0lity
–
Supply
&
Demand
Analysis
Price
Qty
P1
D1
P1
S1
Price
Qty
S1
S2
P2
An
adverse
supply
shock
can
cause
market
prices
to
rise
sharply
especially
when
PED
is
low
(<1)
Rising
market
demand
can
also
cause
price
spikes
–
especially
when
supply
elas3city
is
low
D1
D2
P2

6. Price
Vola0lity
–
Crude
Oil
Prices
(US
$s)
Price
Qty
P2
S1
The
price
of
oil
might
drop
if
actual
demand
is
lower
than
forecast
and
supply
condi3ons
are
more
favourable
Demand
Forecast
P1
0
20
40
60
80
100
120
Jun
14
Jul
14
Aug
14
Sep
14
Oct
14
Nov
14
Dec
14
Jan
15
Feb
15
Mar
15
Apr
15
May
15
June
15
Price
of
Brent
Crude
Oil
in
U.S.
dollars
per
barrel
Demand
Actual
S2

7. Price
Vola0lity
–
Sugar
Prices
Falling
Fast
0
100
200
300
400
500
600
700
Price
per
tonne
in
£s
• The
world
sugar
price
has
been
falling
in
recent
years
• The
main
factor
has
been
much
stronger
supply
helped
by
favourable
weather
condi3ons
and
by
the
lagged
effects
of
the
high
prices
in
2012
and
2013
• Brazil,
India,
China
and
Thailand
are
the
main
sugar-­‐producing
na3ons
• Demand
growth
has
slowed
down
in
part
due
to
health
concerns
in
many
advanced
countries

8. Elas0city
and
Price
Changes
–
Quick
Summary
Elas3city
of
demand
and/or
supply
determines
how
much
a
shi^
in
market
condi3ons
changes
equilibrium
quan3ty
versus
price
Change
in
market
condi0ons
• If
Demand
increases
and
Supply
is
perfectly
inelas3c
(PES=0),
then
price
rises
and
quan3ty
doesn't
change
• If
Supply
increases
and
Demand
is
perfectly
inelas3c
(PED=0),
then
price
falls
and
quan3ty
doesn't
change
• If
Demand
increases
and
Supply
is
perfectly
elas3c,
then
price
stays
the
same
and
quan3ty
rises
• If
Supply
increases
and
Demand
is
perfectly
elas3c,
then
price
stays
the
same
and
quan3ty
rises

9. Shrinking
Market
Demand
for
Film
Video
Rentals
The
volume
of
films
rented
from
UK
retail
stores
has
fallen
sharply
Film
rental
market
volume
in
the
UK
2001-­‐2013
Annual
rentals
(millions)
2001 198
2004 159
2007 92
2010 84
2013 53
Falling
cost
of
fast
broadband
• Increase
speed
of
downloads
• Shi^
in
consumer
preferences
Recovery
in
life
cinema
visits
• Investment
in
digital
projec3on
• Greater
use
of
dynamic
pricing
Film
rentals
seen
as
inferior
good
• Preference
to
download
or
buy
• Real
incomes
rising,
demand
for
rentals
falls
(nega3ve
income
elas3city)

10. Prices
in
Ac0on:
Average
Diesel
Price
in
the
UK
100
105
110
115
120
125
130
135
140
145
150
Jan
13
Feb
13
Mar
13
Apr
13
May
13
Jun
13
Jul
13
Aug
13
Sep
13
Oct
13
Nov
13
Dec
13
Jan
14
Feb
14
Mar
14
Apr
14
May
14
Jun
14
Jul
14
Aug
14
Sep
14
Oct
14
Nov
14
Dec
14
Jan
15
Feb
15
Mar
15
Apr
15
May
15
Jun
15
Jul
15
Price
per
liter
in
pence
The
average
market
price
for
diesel
has
been
declining
steadily
over
the
last
two
years.
The
main
reason
has
been
the
sharp
drop
in
world
oil
prices.
Intense
compe33on
among
petrol
retailers
has
also
led
to
some
price
reduc3ons.

11. Prices
in
Ac0on:
Beer
Prices
Around
the
World
6.32
6.16
5.79
5.31
5.2
5.13
5.13
4.91
4.77
4.66
0
1
2
3
4
5
6
7
Geneva
Hong
Kong
Tel
Aviv
Oslo
New
York
Singapore
Miami
Helsinki
Tokyo
Abu
Dhabi
Beer
price
in
pounds
sterling
(£)
Most
Expensive
Ci3es
for
a
33cl
Beer
1.66
1.66
1.69
1.72
1.75
1.78
1.96
1.97
1.98
2.11
0
0.5
1
1.5
2
2.5
Krakow
Kiev
Bra3slava
Malaga
Delhi
Ho
Chi
Minh
City
Mexico
City
Belgrade
Asuncion
Bangkok
Beer
price
in
U.S.
dollars
($)
Most
Affordable
Ci3es
for
a
33cl
Beer
Current
market
exchange
rate
(July
2015)
£1
=
$1.56
Can
you
use
economic
factors
to
explain
why
beer
prices
vary?

12. Rising
Prices
for
Olive
Oil
Extract
The
price
of
premium
virgin
olive
oil
has
risen
to
$4,282
a
tonne
in
November
2014,
the
highest
since
2008.
A
severe
drought
in
Spain
and
a
fruit
fly
infesta3on
in
Italy
have
caused
a
surge
in
the
price
of
olive
oil.
The
two
countries
normally
account
for
just
under
70
per
cent
of
output.
If
prices
remain
high,
consumers
may
con3nue
to
switch
towards
cheaper
subs3tutes
such
as
soya,
palm
and
rapeseed
oil.
Source:
Newspaper
reports
Q:
Explain
why
the
price
of
olive
oil
has
risen
A:
An
inward
shi^
of
market
supply
causes
increased
scarcity
-­‐
drives
prices
higher.
PED
likely
to
be
low
which
amplifies
price
rises
Q:
To
what
extent
might
the
rise
in
the
price
of
olive
oil
lead
to
a
rise
in
the
price
of
olive
oil
in
UK
supermarkets?
A:
There
are
few
processing
costs
so
a
rise
in
olive
oil
prices
should
feed
through
quickly
But…
• Other
costs
may
be
falling
e.g.
boRling,
wages,
distribu3on
etc.
• Supermarkets
may
maintain
prices
and
be
prepared
to
sacrifice
some
profits.
• A
rise
in
the
£/Euro
exchange
rate
may
prevent
a
price
rise
as
imports
are
cheaper

13. The
Price
Mechanism
EdExcel
Economics
1.2.7