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MICRO-ECONOMICS AND POLICY ANALYSIS

TOPIC: MECHANICS OF INDIVIDUAL PRICES AND CHANGES IN QUALITY

DEMAND.

Submitted to: DR. MARIA ELLEN QUINICIO

Prepared by: Maria Mariniel M. Barroga

 NATIONAL COLLEGE OF BUSINESS AND ARTS

994 Aurora Blvd, Cubao, Quezon City. Tel No. 8913-3991

The Price Mechanism

The interaction of buyers and sellers in free markets enables goods, services,

and resources to be allocated prices. Relative prices, and changes in price,

reflect the forces of demand and supply and help solve the economic problem.

Resources move towards where they are in the shortest supply, relative to

demand, and away from where they are least demanded.

The rationing function of the price mechanism

Whenever resources are particularly scarce, demand exceeds supply and prices

are driven up.  The effect of such a price rise is to discourage demand, conserve

resources, and spread out their use over time. The greater the scarcity, the

higher the price and the more the resource is rationed. This can be seen in the

market for oil. As oil slowly runs out, its price will rise, and this discourages

demand and leads to more oil being conserved than at lower prices. The

rationing function of a price rise is associated with a contraction of demand along

the demand curve.

The signalling function of the price mechanism

Price changes send contrasting messages to consumers and producers about

whether to enter or leave a market. Rising prices give a signal to consumers to

reduce demand or withdraw from a market completely, and they give a signal to
 NATIONAL COLLEGE OF BUSINESS AND ARTS

994 Aurora Blvd, Cubao, Quezon City. Tel No. 8913-3991

potential producers to enter a market. Conversely, falling prices give a positive

message to consumers to enter a market while sending a negative signal to

producers to leave a market. For example, a rise in the market price of 'smart'

phones sends a signal to potential manufacturers to enter this market, and

perhaps leave another one. Similarly, the provision of 'free' healthcare may

signal to 'consumers' that they can pay a visit to their doctor for any minor

ailment, while potential private healthcare providers will be deterred from entering

the market. In terms of the labour market, a rise in the wage rate, which is the

price of labour, provides a signal to the unemployed to join the labour market.

The signalling function is associated with shifts in demand and supply curves.

The incentive function of the price mechanism

An incentive is something that motivates a producer or consumer to follow a

course of action or to change behaviour. Higher prices provide an incentive to

existing producers to supply more because they provide the possibility or

more revenue and increased profits. The incentive function of a price rise is

associated with an extension of supply along the existing supply curve.

 NATIONAL COLLEGE OF BUSINESS AND ARTS

994 Aurora Blvd, Cubao, Quezon City. Tel No. 8913-3991

Diagrammatic explanation

A market starts with a stable equilibrium, where demand equals supply.

A supply shock reduces supply at each and every price. This creates an excess

of demand at the existing price.

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The price is now forced up to a new price (P1) where the market clears.

At the new price, demand and supply are brought into equilibrium through a

contraction of demand (the rationing effect) and an extension of supply (the

incentive effect).
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994 Aurora Blvd, Cubao, Quezon City. Tel No. 8913-3991

In the long run, the higher price sends out signals, either for existing firms to

introduce better production methods or by new firms entering the market. This

causes the supply curve to shift to the right. Eventually, price may return to its

existing level.
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In conclusion, the price mechanism is said to work effectively through a

combination of rationing, incentives and signals.

CHANGE IN QUANTITY DEMANDED

It’s hard to overstate the importance of understanding the difference between

shifts in curves and movements along curves. Remember, when we talk about
changes in demand or supply, we do not mean the same thing as changes
in quantity demanded or quantity supplied.

A change in demand refers to a shift in the entire demand curve, which is

caused by a variety of factors (preferences, income, prices of substitutes and
complements, expectations, population, etc.). In this case, the entire demand
curve moves left or right.
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Figure 1. Change in Demand. A change in demand means that the entire demand curve shifts either
left or right. The initial demand curve D 0 shifts to become either D1 or D2. This could be caused by a
shift in tastes, changes in population, changes in income, prices of substitute or complement goods, or
changes future expectations.

A change in quantity demanded refers to a movement along the demand curve,

which is caused only by a chance in price. In this case, the demand curve
doesn’t move; rather, we move along the existing demand curve.
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Figure 2. Change in Quantity Demanded. A change in the quantity demanded refers to movement
along the existing demand curve, D0. This is a change in price, which is caused by a shift in
the supply curve.
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REFERENCES

https://www.economicsonline.co.uk/Competitive_markets/

Rationing_and_incentives.html

https://courses.lumenlearning.com/wmintrobusiness/chapter/video-change-in-

demand-vs-change-in-quantity-demanded/