(HL Economics series): Role of price mechanism
Welcome back to our lost and found series where we cover the misconceptions that we as students faced and help them get back on the right track! Sadly, some of us did not realise we had these misconceptions till nearing the end of our IB journey. We hope this guide helps prevent possible panic near the examinations where you realise what you have been studying was wrong the whole time.
This week, we will only be covering one aspect of Micro-Economics: The role of price mechanisms. Whilst this does is not a misconception, it is something that students are not familiar with so we thought it will be useful to go through it here. Use this when showing how a new state of equilibrium is reached.
LETS BEGIN!
Explanation of how to use the price mechanism to explain diagrams.
As shown in the diagram below, the market equilibrium for coffee beans is initially found by the intersection between the D1 curve and the S curve. P1 is the initial price of coffee beans and Q1 is the initial Quantity produced and consumed.
Let’s assume that the demand for coffee increased because a recent study showed that coffee has many newly discovered health benefits.
Demand for coffee increases from D1 to D2. (NOW, this is the part where students miss) - At the initial price P1, a shortage occurs, equal to Q2-Q1.
Why do we have to include this line?
(Not an official explanation) Think of it as if there is some lag right after the demand curve shifts to D2. When the lag occurs, consumers are still paying P1 and producers are still receiving P1.
(Okay back to the proper explanation) The shortage occurs because at P1, Quantity demanded > Quantity supplied. (We know this if we draw a line across P1: it intersects the S curve at Q1 , A and the D2 curve at Q2, B). The price of coffee beans thus begins to rise and will rise till the shortage has disappeared. Wait, so when does the shortage disappear? Simple, when Qd = Qs, which is at the new market equilibrium at C.
How to bring in the concept of the price mechanism?
Producers: The higher rising price signalled to producers that there is a shortage in the coffee bean market. This is also an incentive for producers to increase the quantity of coffee beans supplied (Why?) Because of the law of supply! At the higher price, coffee beans become more profitable as they can better cover the cost of production. (Explain the movement) Therefore, producers move along the supply curve from point A to point C, increasing quantity supplied from Q1 to Q3.
Consumers: The new higher price signals to consumers that coffee beans are more expensive and is an incentive to purchase and consume fewer coffee beans. Therefore, they move along D2 from B to C.
Wrapping it up: The increase in price of coffee beans results in a reallocation of resources and more resources are allocated to the production of coffee beans.
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