Price signals, incentives, rationing and the role of profit

Overview

Signalling function of price, incentive function of price and rationing function of price.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Explain the signalling function of price.

   Model answer

   A price carries information about relative scarcity and about what consumers value. A rising price tells producers that consumers want more of the good than is currently being supplied, and tells consumers that the good has become scarcer relative to demand. Nobody has to collect or transmit this information deliberately: it is summarised in a single number that everyone in the market can observe and act on.

2. 2

   Explain the incentive function of price.

   Model answer

   Price does not merely inform; it makes acting on the information worthwhile. A higher price raises the revenue and profit from supplying the good, so producers have a financial reason to expand output and new firms have a reason to enter. A lower price gives consumers a reason to buy more and producers a reason to switch resources elsewhere. Signals without incentives would be ignored, so the two functions work together.

3. 3

   Explain the rationing function of price.

   Model answer

   When a good is scarce relative to the quantity wanted at the existing price, the price rises and the good is allocated to those willing and able to pay the higher price, while others reduce their purchases or go without. Price therefore rations the available quantity among competing users without queues, waiting lists or administrative decisions. It rations by willingness and ability to pay, which is efficient in the sense that the good goes to those who value it most in money terms, but takes no account of need.

4. 4

   A poor coffee harvest raises the world price of coffee beans. Explain how each of the three functions of price operates in this case.

   Model answer

   The higher price signals to everyone in the market that beans have become scarcer relative to demand. It rations the reduced supply, because roasters and consumers who value coffee less switch to alternatives and the smaller crop goes to those willing to pay most. It creates an incentive for growers to harvest and sell every bean, to bring marginal land into production and to plant more trees for future seasons, and for buyers to seek out substitutes. Together the three functions bring the market back towards balance without any authority deciding who goes without.

5. 5

   Explain the role of profit in attracting resources into an industry.

   Model answer

   Profit is the surplus of revenue over cost, so it is high where consumers value the output more than the resources needed to make it are worth in their next best use. High profit therefore identifies an activity where resources are underused relative to what consumers want. Because owners of capital and enterprise pursue the highest return, they move resources into that industry, output expands, and the profit signal is acted upon without any central instruction.

6. 6

   Explain the role of losses in a market economy.

   Model answer

   Losses show that consumers value the output of an activity less than the resources it consumes are worth elsewhere. They force firms to cut costs, change what they produce or leave the industry altogether, releasing land, labour and capital for uses that consumers value more highly. Losses are therefore as important as profits in allocating resources: profit draws resources in and loss drives them out, and a system that suppressed losses would leave resources stuck in low-value uses.

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