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How is price determination related to the different roles of prices in a competitive free market? [10]

In a competitive free market, the equilibrium market price is determined by the intersection of the market demand and supply curves. Prices play four different and important roles in the market, namely signaling, allocating, rationing and providing incentives. After establishing how price is determined and identifying the different roles of prices, this essay seeks to first explain a perfectly competitive market before explaining in detail how the equilibrium price is determined with the aid of a diagram. Thereafter, the different roles of prices will be further elaborated before analyzing the relationship between that and price determination.

How are prices determined? To begin with, a perfectly competitive market is one where there are low barriers to entry, a homogeneous product being transacted between many buyers and sellers and perfect information regarding product prices. The key outcome of such a market is that neither individual buyers or sellers have the ability to influence prices, thus both parties are price takers. The equilibrium market price (PE), which buyers and sellers are equally satisfied with, is thus determined by the intersection of the market demand and supply curves.

[Insert diagram on equilibrium market price and quantity]

As depicted in the diagram, if the price is above PE at $10, the quantity supplied is 100 units while the quantity demanded is 50 units. There is a surplus of 50 units and to clear the excess supply, producers will lower their prices. As the price falls, the quantity demanded rises while the quantity supplied falls, reducing the surplus. The surplus is totally eliminated when the price falls to PE. Likewise, if the price is below PE at $5, the quantity supplied is 50 units while the quantity demanded is 100 units. There is a shortage of 50 units and producers will raise their prices. As the price rises, the quantity demanded falls while the quantity supplied increases. The shortage is totally removed when the price rises to PE.

Moving to the different roles of prices, the first is a signaling function. With a change in consumers’ tastes and preferences, an increase in demand for a good would increase the price of it. Producers would follow these price signals to produce accordingly, with more when the demand of the good is rising and with less when the demand of the good is falling. 

The second is the allocative function of prices. Following an increase in demand and subsequent increase in price for a good is an increase in profit. Hence, producers would channel scarce resources from less profitable to more profitable industries. 

The third is a rationing function of prices. When there are shortages, consumers would bid up the price of the good. Consumers with higher effective demand would get to purchase the good, in turn allowing goods in shortage to be rationed. 

Finally, prices function as incentives for consumers and producers to maximize welfare. For the consumers, when prices fall, they have the incentive to buy more to increase welfare. For the producers, when prices rise, they would have the incentive to sell more to increase profits and welfare. 

Looking at the relationship between price determination and different roles of prices, the signaling role is a movement along the supply curve whereas the rationing role is a movement along the demand curve. The incentivizing role is a movement along both the supply and demand curves while the allocative role needs diagrams of two different markets in order to be illustrated.

JC Economics Essays - H1 H2 H3 A Levels Economics, adapted question (part (a)): economics tutor's comments: Students sometimes do not do enough revision for the role of prices in a free market because they take it for granted, but a moment's reflection should inform students about the complexities of studying economics. What are the roles of prices? How are these related to the supply and demand diagram? (Remember that diagrams are very important in Economics.) Supply and demand economics questions are not limited to just factors affecting demand and supply, and elasticities. In this particular economics essay, there does not seem to be an essay conclusion, but having said that the essay's introduction was fairly well written - what makes for a good conclusion, and what makes for a good essay introduction? Special thanks to contributions by some motivated, hardworking, and generous students who share their skills, services, and materials. Just for interest: Milton Friedman's "pencil" concept on the free market can be found on YouTube. Do watch it just for interest about understanding the intuition behind the economics concept of the free, competitive, unfettered market.

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