Price Mechanism | A-Level Economics Model Paragraph (AQA, Edexcel, OCR)

• excess demand
• ration
• incentive
• evaluation
  • only those who are willing and able to buy will benefit
  • is this unfair and unequal?
  • market is impartial and no risk of government failure
  • market is also able to signal for INNOVATION e.g. Uber/ Zoom

In the free market, equilibrium is the price and quantity at which demand meets supply. The price mechanism has three functions (ration, incentive and signal) and this solves the basic economic problem of allocating scarce resources.

In the example of housing, the price mechanism will be able to solve the issues caused by an increase in population or and an increase in incomes, which would cause a right shift in demand.

The first diagram shows that, if there is a right shift in demand, there would be very number of houses (q2) that people are willing and able to buy at p1, and a low number of houses (q1) who firms are willing and able to sell at p1. The gap between q1 and q2 is the excess demand. The market will adjust prices higher and higher until there is a new equilibrium, as shown by the second diagram - at q2 with a price of p2. This is known as the rationing function - higher prices rationed away the excess demand - so houses are bought and sold only by those who are willing and able. The high price also provides a greater profit motive, and this incentivises firms to increase the number of houses available for sale. Hence, there is a higher equilibrium quantity of q2. This is also known as the invisible hand of the market. There is always an efficient allocation of resources and there is no risk of government failure.

On the other hand, the market fails to acknowledge the possible nature of houses as a merit good. A merit good is a good which has positive externalities in consumption. You could argue that the consumption and ownership of a house provides a benefit to third parties in society such as the taxpayer, or employers. For example, those who are settled in their own home may be less likely to engage in crime. The issue with relying purely on the free market is that the market only allocates goods and services to those are willing and able to buy. You could argue that this is either unfair or damaging to society.

However, the market does also have a powerful signalling function. High house prices could signal that there is a chance to profit from property development in nearby areas. Or cheaper house prices outside of London could signal for families or businesses to move out of London. We have seen the signalling function enable invention and innovation in the past, such as with high taxi prices and low supply leading to the invention of Uber - or COVID leading to an increase in demand for software like Zoom and Teams.