Microeconomics Essay Example | Topics and Well Written Essays - 2000 words

Microeconomics - Essay Example The theory of â€Å"invisible hand† proposed by the father of economics, Adam Smith, refers to this theory of price. According to Smith, prices are the sacrifice made by customers in order to make a utility gain through consumption of the good or service and the gain made by producers by selling the product that they have produced. Therefore, any rational consumer would be willing to make lesser sacrifice for a comparatively larger amount of gain. On the other hand, producers or sellers would desire to be willing to earn more by selling their product than the sacrifice they have made during producing the good. The market comes to equilibrium at the point at which both the decisions regarding buying and selling the good intersect with one another. This phenomenon is termed as the invisible hand, since the market operates without intervention by any third party (Mankiw 26). Figure: Free market equilibrium (Source: Author’s creation) Three important functions are played by price mechanism in a competitive market economy. These are signaling function, rationalling function and incentive function. Signaling function Prices of goods and services in a competitive market economy demonstrate the rate of availability or scarcity of resources in the market. It indicates whether resource is allocated adequately in different sectors in the economy (Adil 71). In the long run, high price level signals producers to enter the market, while customers are signaled to leave the market and look for cheaper substitutes. Therefore, supply rise and demand falls. Figure: Signaling effect (Source: Author’s creation) Rationalling function Prices can ration scarce resources when market demand is much higher than market supply. If market demand is higher, price would rise, thereby making the good available to those customers only that have the demand for the good backed by purchasing power. It helps to bring the market to equilibrium from a position of disequilibrium b y equaling demand with supply (Boyes and ?Michael 26). Incentive function Price mechanism plays an active and important role in the market economy. Price of a good is the incentive for both buyer and seller to buy or sell the product. For successful running of a competitive market, prices should be efficient enough to incentive the economic agents to involve into economic transactions. Figure: Rationing and incentive effect (Source: Author’s creation) If there is excess demand it raises price. Incentive effect allows suppliers to increase supply while rationalling effect makes buyers to reduce demand. This leads to a new equilibrium (from e to e2). Answer 2: Demand and supply are two basic forces that operate in a competitive market structure. Price plays an important role in determining the equilibrium quantity of demand and supply in this type of economy. Although economic theory simplistically states that there is negative relationship between price of a product and its de mand and positive relationship between price of the product and its supply; there is a difference between expansion and increase in demand or supply for a good or service and contraction or decrease in demand or supply for a good or service (Friedman 13). Expansion or contraction in demand or supply Demand (or supply) can change either due to change in price of the good (or service) or due to change in other variables affecting price.