Market Mechanism Work

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1.0 Introduction

This assignment shall be describing the workings of the market mechanism, I shall be explaining how prices are determined through the interaction of supply and demand, and this is then further illustrated with graphical representation. From explaining supply and demand I then move onto the equilibrium price and illustrate how supply and demand curves lead to the equilibrium price and what this shows.

In the second part of the assignment I begin to discuss reasons why markets fail, for this section I look into area such as Public goods, ignorance and uncertainty and externalities. From here I provide some examples of real situations in which market failures have caused problems......

The final section of the assignment is the conclusion, this section will contain all the information stated in the assignment in a basic summarized format, it will briefly mention all that has been discussed and will include what

2.0 Market mechanism

The Market mechanism is mainly known as a procedure of assigning resources and also for decision making as decision will have to be made on how much of a particular good or service will be produced, furthermore it acts as a alternative method of making decision without having any involvement from the government. The use of demand and supply within the market mechanism helps when It comes to solving problems in relation to distributing resources efficiently. Economics is mainly focused on the society and how they can satisfy their wants fully even thought there are very limited resources to fulfill these wants.

3.0 Demand and supply

Rises in demand usually lead to rises in price, due to this firms are then encouraged to produce more of the goods, therefore the quantity supplied will also rise. When there are goods which are priced lower in relation to their costs firms will have a tendency to redirect the resources which were used on these goods and place the resources into higher priced goods which are more profitable.

When demand falls this then causes the prices to lower. This causes a reverse affect to when demand increases as firms then produce less as the goods are now not as profitable to produce.

When supplies rise on a good this then leads to price drops on the good, this forms an encouragement for consumers to buy more due to the price drop. And this causes the demand to rise.

Supplies will fall when prices rise, this then discourages the consumers and so they will buy less and thus the quantity demand falls.

4.0 Demand

When a goods price increases, the demand for that good will fall, this is known as the law of demand. A reason fro this law could be that consumers will feel poorer, this will be because increasing the prices will mean that the consumer will not be able to afford to buy as much of the good with their own money. This is the income effect of a rise in price. Another reason may be that the goods will now appear more prestigious in comparison to other goods, this will cause other people to switch to the alternative good. This is known as the substitution effect of a price rise.

However when the prices for goods fall, this will cause a rise in the quantity demanded. As prices fall people will be able to afford more of the goods, and due to this the substitute good will no longer be chosen.

4.1 Demand curve

Below is an example of how the demand curve works, as you can see the graph shows that as the price of a good goes down the quantity demanded increases. The graph is visual shows how demand works in relation to price.

Apart from price there are a few other factors which affect the demand of a product, these include:

  • Tastes
  • The number and price of substitute goods
  • The number and price of complementary goods
  • Income
  • Distribution of income
  • Expectations of future price changes

When it comes to taste if people desire the product, then the demand for the product will increase, methods in which tastes can be influenced include the current fashion, advertisements and also by observing others.

The second point is in relation to a good and its substitute goods, also known as competitive goods. If the substitute good is higher priced then this good then the demand for this good will increase as people will switch to it rather than the more expensive substitute good.

Complementary goods are those which are placed together (e.g. bread and butter). If the complementary good is highly priced this will mean that there will not be many of them bought which then results in fewer of the original good being bought.

If a persons income rises there demand for any good will also increase, these goods are known as normal goods. Furthermore whilst their income increase consumers will end up spending less on what are known as inferior goods, these are cheap goods which have substitute goods of much better quality.

For expectations of future price changes, if consumers expect that prices will rise in the future then they will be more likely to buy much more before the prices begin to rise.

5.0 Supply

The main idea of supply is that when the price of a good rises, the quantity supplied will also rise.

There are 3 main reasons why this occurs, the first is that as firms supply more, their costs will begin to rise at a quicker amount. It will only be worth producing more if the price rises as the increase in production will incur the higher costs. The second reason is that the higher the price of the goods become the more profitable those products become to those who produce and supply. This encourages the producers to produce more of the profitable goods instead of less profitable. And the third reason is that after some period if the price of the good is still high then there will be new producers which will be encouraged to produce the good and this will lead to the increase in the amount supplied.

5.1 Supply curve

The supply curve as seen below shows you that as the prices increase so does the quantity which is supplied. The graph shows what has previously been explained when describing how supply works.

As supply is not only determined by price, there are other factors which influence the supply.

One of the factors are the cost of production, the higher the costs of production are the less money which will be made out of the goods. Because of the higher costs this will also lead to a lower amount in production, this may lead to firms changing onto alternative products which ay be cheaper to produce.

Another reason may be the fact that there may be substitute goods which may be becoming more profitable then the current good being supplied.

At times when a good is being produced there will be another good which is also being produced at the same time, this is known as goods in joint supply. If the other good is being produced due to a raise in demand that will cause this good to also rise in supply.

Supply may also be affected by the aims of the firms as the quantity supplied by a firm which has an aim in maximising sales will be different to the amount supplied in a firm which aims to maximise profits.

6.0 Equilibrium price

The point in which demand equals supply is known as the equilibrium price. The word equilibrium itself means a point of balance. If the demand or supply in any given firm change this will cause the equilibrium price to change, as an increase in.......

The graph below shows how the equilibrium price is formed, as you can see both the demand and supply curve are shown within the graph and the point in which both curves meet is the equilibrium point which is known as the Equilibrium price. (info obtained from microeconomic book)

7.0 Reasons for market failure

Relate to possible market failures

* Include real world examples

market failures:

  • Externalities
  • Public goods
  • Market power
  • Ignorance and uncertainty
  • Protecting people's interests

There are a number of reasons for market failure, the three which will be explained here will be externalities, public goods and ignorance and uncertainty.

7.1 Externalities

Externalities occur when the effectiveness of the market leads to action from the consumers which affect people other than themselves. It is known as the 'third party effects' of production and consumption. Externalities have both positive and negative features, when others have been affected positively it is known to be eternal benefits, whilst when other people are affected negatively it is then known to be external costs.

An example of an externalities is the light post example, a woman may use here own money to pay to get the lights fixed on her (_____) but once they work she will not be the only one benefiting from this as any one going by will benefit from the light and therefore she is spending money on something which is benefiting others.

7.2 Public Goods

There are categories of goods in which the positive externalities are so great that the free market regardless of whether it is perfect or flawed may not produce at all. Examples of such goods include flood control dams, lighthouses and public drainage.

An important aspect of public goods is that they have two types of characteristics

Market power ( might not do)

7.3 Ignorance and uncertainty

Perfect competition assumes that....

However in real world situations there is a high amount of ignorance and uncertainty. and because of this people find difficulties in associating marginal benefit with marginal cost. There are some goods which consumers will only buy a few times in there lifetimes, these include cars, washing machines and televisions. Many times consumers don't know about the quality of the goods they are buying until after they have bought them, which by that time is too late. Advertising may further influence the ignorance of the consumers as it may give deceptive benefits of the product.

Firms themselves have uncertainties on market opportunities, prices and costs. Many decisions which businesses make are based on expected future outcomes. Due to this many of the outcomes do not occur and so the business gets these expected future outcomes wrong.

Look into articles and other websites given through links within power point

Get info from book but articles are more important as they act as a evidence

good for brief intro into the market failure

8.0 Conclusion

Throughout this assignment I have been explaining the workings of the market mechanism, this involved explaining the demand and supply process.

  • Shown graphs
  • And other factors which affect the s and d
  • Then spoek about the reasons behind a markets failure
  • And describe the examples
  • And give a final analysis

In conclusion it has been shown that demand and supply...

9.0 Bibliography

  1. L. Davison, (2006), The Business Environment - 4th edition
  2. Z. Stefano, (1987), Microeconomic theory - An Introduction