the price mechanism in action

AS Micro

The Price Mechanism in Action!

Geoff Riley, FRSA, Eton College & Tutor2u

Functions of the Price Mechanism

1. Allocation – allocating scarce resources among competing uses

2. Rationing – prices serve to ration scarce resources when demand outstrips supply

3. Signalling – prices adjust to demonstrate where resources are required, and where they are not

4. Incentives – when the price of a product rises, quantity supplied increased

Incentives matter!

Markets in Action – Crude Oil

Applying supply and demand analysis

Changing supply / demand conditions

Market Change Shift in Supply or Demand?

Rise or Fall in Market Price for Crude Oil?

• There is a steep slowdown in the Chinese economy

• OPEC agrees to an increase in output quotas for each of their members

• There is a fall in the number of active oil rigs in many of the world’s major oil producers

Changing supply / demand conditionsMarket Change Shift in Supply or

Demand?Rise or Fall in Market Price for Crude Oil?

• There is a steep slowdown in the Chinese economy Demand

Price of crude oil

Quantity of crude oil

D1D2

S1

Q1Q2

P2

P1



• OPEC agrees to an increase in output quotas for each of their members Supply


Price of crude oil


D1

S1

Q1 Q2

P2

P1S2

Oil Rigs and Price IncentivesHigh oil prices increase the incentive to drill for oil

Deepwater oil rigs now cost between around $600m to build



• There is a fall in the number of active oil rigs in many of the world’s major oil producers

Supply


Price of crude oil

D1

S1

Q1Q2

P2

P1

S2

Impact of changing oil prices

Oil Industry

• Exploration & Drilling

• Investment

People• Cost of living• Real incomes

Related sectors

• Oil substitutes• Oil supply

chain industries

Connections

Connections

StakeholdersGroups who benefit from high oil prices

Oil companies

Oil exporting nations

Government – oil taxes

Renewable energy industry

StakeholdersGroups who benefit from high oil prices

Groups who lose out from high oil prices

Oil companies Motorists

Oil exporting nations Transport businesses e.g. airlines, road haulage

Government – oil taxes Higher energy prices - consumers

Renewable energy industry Businesses hit by falling real incomes of households

The Global Market for Aluminium

Aluminium Prices

Shifts in supply & demandMarket Change Shift in Supply

or Demand?Rise or Fall in Market Price for Aluminium?

A fall in demand for new long-haul aircraft

Tighter fuel-efficiency standards for new vehicles in the USA

A persistent fall in the world price of steel

A rise in the price of bauxite (used in manufacturing aluminium)

P7




DEMAND FALL




Please use BIG DIAGRAMS – large, clear diagrams are easier to mark and credit!

Shifts in supply & demandA fall in demand for new long-haul aircraft

DEMAND FALL

Price of Aluminium

Demand

Supply

P1

Q1 Quantity of Aluminium


DEMAND FALL

Price of Aluminium

Demand

Supply

P1


D2


DEMAND FALL

Price of Aluminium

Demand

Supply

P1


D2

P2

Q2




DEMAND FALL


DEMAND RISE






DEMAND FALL


DEMAND RISE


DEMAND FALL





DEMAND FALL


DEMAND RISE


DEMAND FALL


SUPPLY RISE

Shifts in supply & demand

Price of Aluminium

Demand

Supply

P1


D2

P2

Q2


SUPPLY RISE

S2

Shifts in supply & demand

Price of Aluminium

Demand

Supply

P1


D2

P2

Q2


SUPPLY RISE

S2

P3

Q3

Price of Aluminium

D1

S1

P1

Q1Quantity of Aluminium

Price of Pepsi Max

Di

Si

Pi

Qi

Inter-related markets

Quantity of Pepsi Max

Price of Aluminium

D1

S1

P1


Price of Pepsi Max

Di

Si

Pi

Qi


D2

P2

Q2 Quantity of Pepsi Max

Price of Aluminium

D1

S1

P1


Price of Pepsi Max

Di

Si

Pi

Qi Quantity of Pepsi Max


D2

P2

Q2

Sii

Pii

Qii

Analysis

Evaluation

Application

Good application opens the door to good analysis and good evaluation

”A new norm of high prices seems to

be consolidating, and the world

cannot afford to be complacent to this

trend while 870 million people still live in hunger and

millions of children die every year from

preventable diseases caused by

malnutrition.”

Why are prices volatile in the markets for many commodities?

Low Ped (<1)

Low Pes (<1)

Volatile Supply Shocks

Market Specula

-tors

Double diagrams can be a handy way of analysing

changing elasticity of demand and supply

Using analysis diagramsPrice

Quantity

Price

Quantity


Quantity

Price

Quantity

S1

D1

RISE IN MARKET DEMAND


Quantity

Price

Quantity

S1

D1 D2

P1

P2

RISE IN MARKET DEMAND


Quantity

Price

Quantity

S1

D1 D2

P1

P2S1

D1

RISE IN MARKET DEMAND RISE IN MARKET SUPPLY


Quantity

Price

Quantity

S1

D1 D2

P1

P2S1

D1

S2

P1

P2

RISE IN MARKET SUPPLYRISE IN MARKET DEMAND

Problems arising from price volatilityRisk and Uncertainty• Uncertain incomes and profits for farmers• May limit capital investment / productivity

Extreme poverty and unemployment• Millions of smaller farmers in the world• Many do not gain when world prices rise• Monopsony power of commodity buyers

Macroeconomic effects• Volatile export revenues affects trade balance• Causes inflation and extreme food poverty

Get help from fellow students, teachers and tutor2u on Twitter:

#econ1@tutor2u_econ

the price mechanism in action

Business

price of bauxite

price mechanism1

inmarket price foraluminium

inmarket price forcrude

supplyor demand

world price ofsteela

supply ordemand

supply demanda