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Question 2)June 2003 Paper 2
Part A)Explain the functions of price in a market economy(model answer)
Answer)
All economic systems have to answer the four basic questions of what to produce, how much to produce, and for whom to produce and how to produce.In a market economy, this is determined by the price mechanism.In this system,it is assumed that there is a competitive situation situation in each industry.The market is characterised by individual choices on the part of the consumers and producers.Competion is the second main characteristic. Consumers have to compete for products they want and producers have to compete for sales.
In the market,thousands of consumers expressed their demand,which is the desire and ability to pay. Producers express their supply which is the wish and ability to sell their goods.These two forces interact to give price.Price measures opportunity cost, that is, what is given up due to a choice of buying or selling.
The combination and the analysis of demand and supply will give the equilibrium price and quantity.For each good,there is a supply schedule and demand schedule.If two are brought together, we find that the quantity demanded and quantity supplied will be equal at one and only one market price.This is is the equilibrium price which is P and the quantity demanded will be at equilibrium level Q.
(Draw a normal supply and demand curve)
Therefore,the price P tells us what goods and services to produce(using the supply curve) and consume( using the demand curve).
In a market economy only products that can command a price should be produced.Rising prices signals that more should be produced.Falling prices does the reverse. Similar analysis can be applied to the demand and supply of labour.The demand of labour will be downward sloping.This is because at a lower wage rate,employees will demand more units of labour since the cost of labour is cheaper and vice versa.
The supply of labour will be upward sloping.This is because at a higher wage rate,workers will supply more units of labour since wages are higher and the reverse is true for lower wage rate.The price of labour is the wage rate given at W and the equilibrium quantity of labour demanded and supplied is at level N.
(draw a normal demand and supply curve)
There fore prices tells what employment to seek (using the labour demand curve) and what to offer(using the labour supply curve)
Like wise the market for land is brought into equilibrium by changes in its price, that is, rent.For capital,it is price called interest.
