Role of Price Mechanism &

Market Efficiency
Unit 2 - Lesson 5
Learning Outcomes
● Define all terms appearing in orange bold in section 2.5
● Analyse the price mechanism with respect to its functions including:
○ Resource allocation (signalling and incentive)
○ Rationing
● Explain the meaning of consumer and producer surplus, as well as social or
community surplus.
● Draw a diagram showing maximum social surplus at equilibrium.
● Explain the conditions for allocative efficiency at competitive market
equilibrium.
○ Social surplus is maximised.
○ Marginal Benefit is equal to Marginal Cost
● Calculate consumer and producer surplus from a diagram.
Analyse the price mechanism with respect to its functions in resource
allocation.
Invisible Hand of the Market - Adam Smith

Coordination of many consumers and producers in a market without any intervention.

What/how much to produce question of resource allocation is answered.

● Firms produce only those goods that consumers are willing and able to consume.
● Consumers only buy those goods that producers are willing and able to supply to
the market.

How to produce question of resource allocation is answered.

● Firms use those resources and technologies in their production process that they
are willing and able to pay for.
Analyse the price mechanism with respect to its functions in resource
allocation.

● Market is in equilibrium - point A - price

(P1) and quantity (Q1).
● Change in a non-price determinant of
demand - tastes and preferences.
● Results in an increase in demand (D1 -
D2).
● After the increase in demand at original
equilibrium price (P1) there exists excess
demand (difference between point B -
point A)
Analyse the price mechanism with respect to its functions in
resource allocation.
● Signals the market to increase price (P1 - P2).
● Increase in price (P1 - P2) decrease the quantity
demanded (Law of Demand - inverse relationship
between price and quantity demanded) - from point
a - c.
● Increase in price (P1 - P2) increases the quantity
supplied (Law of Supply - positive relationship
between price and quantity supplied) - from point b
- c.
● A new equilibrium price and quantity are set at
point c - P2 and Q2.
● An increase in demand results in an increase in
price and increase in quantity supplied.
Analyse the price mechanism with respect to its functions in
resource allocation.

The increase in the price results in a

reallocation of resources.

More resources are now being allocate

to the production of this good.

Affects the what to produce question of

resource allocation.
Analyse the price mechanism with respect to its functions in
resource allocation.

Resource Market: Labour Market

Vertical Axis: price of labour or wages.

Demand: firms interested in buying labour

services

Supply: the number of workers in the

market willing and able to work at various
prices (wages).
Analyse the price mechanism with respect to its functions in
resource allocation.

● Market is in equilibrium at point A with a

wage (W1) and Q1 quantity of labour.
● Change in a non-price determinant of
supply - number of immigrants increases.
● Increase in supply (S1 - S2).
● After the shift, at the original wage (W1)
there exists excess supply of labour
(point B - A).
● Surplus causes wages to decrease from
W1 - W2.
Analyse the price mechanism with respect to its functions in resource
allocation.

● Wages decrease until the quantity of labour

demanded by firms is equal to the quantity
supplied of labour.
○ Wage (W2) and Q3 quantity of labour
● Falling wages acted as a signal and
incentive.
○ Signalled firms there was a surplus of
labour in the market - point B - A.
○ Decreasing wages incentivized them
to hire more labour - increase in
quantity demanded - point A - C.
Analyse the price mechanism with respect to its functions in
resource allocation.
● Lower wage (W2) signals the workers,
providing them with an incentive to reduce
the quantity supplied of labour in the market
(Law of Supply) - point B - C.
● Offer less labour at lower wages - W1 - W2.
● Firms and workers responded to price
signals and incentives, there occurred a
reallocation of labour resources.
● Firms now employ a greater number of
workers Q1 - Q3 at a lower wage W1 - W2.
● This affects the how to produce question of
resource allocation.
Analyse the price mechanism with respect to its rationing function.

Rationing: allowing each household to have a fixed amount/quantity.

● Market mechanism uses price rationing (whether a consumer is able to get the
good is based off the price of the good.
● Anyone that is willing and able to pay the price of the good will receive the good.
● Anyone who is not willing and/or able to pay the price of the good will not receive
the good.
● Price and price alone is the rationing mechanism.
● The price rationing is the market mechanism working as described by Adam
Smith and the Invisible Hand of the Market.
● Anytime the price mechanism is not working such as cases of government
intervention the market will create surpluses (quantity supplied > quantity
demanded) and shortages (quantity demanded > quantity supplied).
Explain the meaning of consumer and producer surplus, as well as social or
community surplus.

Allocative Efficiency - producing the combination of goods and services most

desired by society.

● Achieved when the economy allocates its resources so that society gets the
most benefit from consumption.
● Answers the what to produce and how much to produce question.
Explain the meaning of consumer and producer surplus, as well as social or
community surplus.

Marginal Benefit: the additional benefit a consumer receives from consuming one
additional unit of a good or service (previously discussed as reason for Law of
Demand).
● As a consumer purchases one additional doughnut, the benefit/utility
received is less than the previous doughnut.
● As consumption increase the benefit/utility received decreases.
● Since marginal benefit decreases as quantity of goods consumed increases,
consumers would only be willing to buy an extra doughnut if the price
decreases.
● Therefore, the demand curve can also be called the marginal benefit curve.
Demand (D) = Marginal Benefit (MB)
Explain the meaning of consumer and producer surplus, as well as social or
community surplus.

Marginal Cost: the cost to produce an additional unit of output.

● A producer can only produce more output if the price of the good or service
sold increases to cover the cost to produce each additional unit.
● Since marginal cost, cost to produce an additional unit of output, increases
as the quantity of the good increases.
● Producers will only be willing to produce an additional unit of the good if the
price increases.
● Therefore the supply curve can also be referenced as the marginal cost
curve.

Supply (S) = Marginal Cost (MC)

Explain the meaning of consumer and producer surplus, as well as social or
community surplus.

Allocative Efficiency occurs when the marginal benefit (MB) is equal to the
marginal cost (MC).

● When marginal benefit, additional benefit a consumer receives from consuming

one additional unit, is equal to the marginal cost, additional cost to produce one
additional unit, society has allocated the right amount of resources to the
production of the good.
● The economy is now producing the quantity most desired by society therefore the
market can be said to be allocatively efficient.

If marginal benefit (MB) > marginal cost (MC) then the benefit society receives from
the last good produced is more than the cost to produce the good.
If the marginal cost > marginal benefit the cost to produce the last unit is more than
the benefit received by society. Therefore the market is allocatively inefficient.
Explain the meaning of consumer and producer surplus, as well as social or
community surplus.

Consumer Surplus: the highest price a consumer

is willing and able to pay for a good minus the price
actually paid.

Area located above the price and below the

demand curve.

Producer Surplus: the lowest price a firm is will

and able to receive minus the price actually
received.

Area located below the price and above the

supply curve
Explain the meaning of consumer and producer surplus, as well as social or
community surplus.

Social (Community) Surplus: sum of consumer

and producer surplus

At competitive market equilibrium where the

marginal benefit is equal to the marginal cost
consumer and producer surplus (community
surplus) is the largest it can be.

At competitive market equilibrium, the social

surplus is maximized.

Maximum social surplus occurs where MB = MC,

therefore maximum social surplus is another way of
saying there is allocative efficiency.
Calculate consumer and producer surplus from a diagram.

Price intercept: the point where the demand

and supply curve intersect the price axis.

Consumer surplus is located above the price

($3) and below the demand curve.

Consumer surplus is the area of the right

triangle.

CS = (Price intercept - Price) x (Quantity

Equilibrium) 2

CS = (6.5 - 3) x 4.5 2

CS = $7.88
Calculate consumer and producer surplus from a diagram.

Producer Surplus: Located below the price

and above the supply curve.

PS = (Price - Price intercept) x Quantity

Equilibrium 2

PS = [(3 - 1) x 4.5] 2

PS = $4.50

Community Surplus = CS + PS

CS = $7.88 + $4.50

Community Surplus = $12.38

Calculate consumer and producer surplus from a diagram.

Sometimes the supply curve does not intersect the

price axis.

When the supply curve intersects the quantity axis,

you will need to find the area of the trapesium.

Area of Trapezium = (a + b) x c 2

Trapezium = (4 + 2) x 3 2

PS = $9

Community Surplus = $7.88 + $9

Community Surplus = $16.88