UNIT 9: PRINCE MECHANISM
Key unit competence: To be able to analyze the role of price mechanism in the allocation of resources
Introductory activity 9.
Assess the local market of agricultural products in your home town as well as the the behaviors of suppliers and -consumers in the two different situations: When there is an abundance of Irish potatoes are and when Irish potatoes are scarce.
Then respond to the following questions:
1. When there is plenty of Irish potatoes and
2. When Irish potatoes are scarce.
Then respond to the following questions:
a) What price changes do you anticipate in both situations? when does the price rise and when does it fall?
b) In which situation does the demand rise and when does it fall?
c) What are the advantages and disadvantages of prices being fixed by the forces of demand and supply?
d) If price fluctuation occurs regularly in your home place, what do you think would be the effects?
e) After analyzing the above effects, what advise would you give the government to control price changes?
9.1. Meaning, advantages, and disadvantages of price mechanism
Learning activity 9.1
1. With tangible examples, explain how price can be determined by the forces of demand and supply.
2. If there is no government intervention in fixing of prices how are the prices determined?
9.1.1. Meaning of price mechanism
Price mechanism refers to the system whereby resources in an economy are allocated by prices. Under this system (also known as Price system) the prices are determined by forces of demand and supply; producers aim at profit maximization and consumers aim at utility maximization. Because producers decide what to produce basing on consumer’s choices, there is what is called “Consumer sovereignty” and therefore, the government’s intervention in the production decisions is null.
Price mechanism works/ operates under free enterprise economy, where all goods and services carry price tags with them. A whole set of prices prevail in such economy.
9.1.2. Advantages and Disadvantages of Price mechanism
i) Advantages of price mechanism
• Price mechanism promotes efficient allocation and use of resources. Due to competition and desire to maximize profits, resource owners allocate them more efficiently to avoid wastages.
• Under price mechanism, there is economic growth. Producers do research, invention and innovations which leads to increase in production and improvement in technology therefore resulting into economic growth.
• Efficiency in production: There is competition between producers. These will cut on costs to compete favorably in the market.
• There is speculation underprice mechanism. Speculators ensure steady supply of commodities. Consumers are offered a chance to access commodities all the time.
• Price mechanism encourages acquisition and distribution of commodities from areas where supply is high to areas where there is little or no supply. This also ensures a ready supply of commodities to the consumers
• Price mechanism answers the following economic questions:
a) What to produce: Producers produce commodities that fetch high profits.
b) How to produce: The method of production used should be cost effective.
c) For whom to produce: Producers manufacture or produce commodities when they are assured of a ready market for the goods.
d) When to produce: Commodities are normally produced when needed.
• It encourages effective distribution and redistribution of resources. Resources are distributed to areas where they are rewarded favorably depending on their demand and prices. Land is used in areas where rent is high, labour goes to where wages are high and capital where interest is maximum.
• Price mechanism works automatically. It therefore does not require the government to put in a lot of resources for implementation. This makes it cheap to operate. It is the responsibility of the government and gives it a chance to concentrate on other areas.
ii) Disadvantages of price mechanism
– Price mechanism promotes income inequality. Resource owners earn more incomes than those without.
– The high cost and inefficient firms are pushed out of business by the most efficient ones. This kind of competition may result in a monopoly in the long run.
– The desire to maximize profits is high under price mechanisms. This profit-oriented motive can make producers supply us with substandard or counterfeit products or exploit consumers who have little information about the market.
– Since there is no government control in the price mechanism, there may be introduction of harmful and illegal products to the market.
– Too much competition may eliminate upcoming and small firms from the market. This may lead to under utilization of some resources.
– Unprofitable but essential commodities may disappear from the market. Private producers aim at making profits and not providing satisfaction or essential commodities. Private producers of much more benefits may overrun public benefits. Producers aim at satisfying their individual interests and not public interest.
– The price system cannot provide public goods some of which are not profit making. For instance, streetlights may not be provided by the private sector which aims at profit making.
– Price mechanism may bring about price fluctuations. Change in demand and supply result into price changes in the market. When demand exceeds supply, price increases. When supply exceeds demand, price lowers.
Application Activity 9
1. How does the price mechanism operate?
2. With real life examples from your community or country, analyse the advantages and disadvantages resulted from price mechanism
9.2. Solutions to shortcomings of price mechanism
Activity 9.2
Propose the solutions to address challenges of price mechanism.
The disadvantages of price mechanism can be rectified through the following means:
– Taxation: Differences in incomes created by price mechanism can be corrected through taxation. In this case, the rich may be taxed more than the poor. As a result, the negative outcomes of price mechanism may be reduced.
– Price control: Private producers in most cases cheat consumers by increasing prices. As a result, price control measures are put in place to curb this problem. This is done mainly by the government, through setting the minimum and maximum prices for the commodities. This prohibits producers with monopoly powers from increasing prices unnecessarily so as to maximize profits.
– Economic planning: The government carries out short term and long-term economic planning. This planning ensures provision of services and utilities that cannot be provided by private entrepreneurs. This also helps to bring about quick structural changes that price mechanism cannot enforce.
– Formation of consumer associations: This protects consumers against exploitation by the profit motivated private producers. It increases the negotiating capacity of consumers. Consumer associations also provide market information to consumers.
– Government support: The government may subsidize weak firms. This helps the upcoming or weak firms to grow, expand and compete with other firms in the market. Competition improves the quality of products.
– Using anti-monopoly/Anti-trust laws: Such laws remove the basis of monopoly created through price system. These prevent firms from merging to become monopolies.
– Nationalization: The government may take over private firms as a way of controlling the private sector. This reduces private interest that could overrun the public interest in the price system.
Application Activity 9.2
1. Explain how nationalization can better settle the problems of price mechanism than privatization.
2. How can taxation play a great role in solving problems of price mechanism.
9.3. Price fluctuations
Activity 9.3
Visit the website of National Institute of Statistics of Rwanda (NIR) and gather information on the prices of different agricultural commodities in the 2 last years.
Discuss and answer the following questions.
a) Were there frequent changes in the prices of commodities?
b) If yes, identify the reasons and solutions for such changes in prices.
9.3.1. Meaning of price fluctuation
Price fluctuation is the continuous alternate rise and fall in prices of commodities. This is mostly common in the agricultural sector. Usually during the planting seasons, prices for agricultural products are high. After harvest, prices reduce. Without government interventions, in periods when supply for agricultural products is high, prices are low. When supply reduces, prices increase. Therefore, the differences between supply and demand in the agricultural sector and failure to regulate supply basically 190 Experimental version explain the constant price fluctuations. Price fluctuations are illustrated by use of cobweb models.
9.3.2. Causes of price fluctuations of agricultural products
As discussed in the previous paragraphs, the differences between supply and demand in the agricultural sector and failure to regulate supply basically explains the constant price fluctuations.
These differences can be as a result of:
i) Perishable commodities: Most agricultural products are perishable. They cannot be kept for long. Before harvest, supply is down. At this time, demand is greater than supply. This forces the prices to rise. After harvest, supply is high. It exceeds demand. This forces prices of commodities such as tomatoes, bananas, onions, and vegetables to fall, failure to which the goods may rot and fail to be sold.
ii) Long gestation periods: There is usually a long-time lag between planting season and harvesting period. Immediately after planting, supply remains very low. Because of low supply, prices are high. When harvesting season sets in, supply increases. As supply keeps increasing, prices of agricultural products keep on reducing
iii) Difference between planned output and actual output. Agricultural production mostly in developing economies largely depends on natural conditions or factors. These include the amount of rainfall received, effects of pests and diseases, and changes in weather conditions. These factors affect agricultural output either positively or negatively. As a result, farmers’ expected output may vary from what is actually harvested, depending on how favorable or unfavorable these natural conditions were. When the natural factors are favorable, agricultural harvest may be higher than what was planned. This may lead to a decrease in the price, as there is more supply. On the other hand, when natural conditions become hostile, agricultural harvest reduces. Consequently, prices will rise due low supply in the market.
iv)Agriculture in developing economies is practiced by many, small scale producers. Most producers use old methods of production. Regulating output to equate it with demand is difficult. This causes fluctuations in prices.
v) Agricultural producers in developing countries produce similar products. They compete for the available market. Thus in case of surplus output, it may not be absorbed by the market which in turn forces selling prices to go down.
vi)Absence of effective commodity programs. Most developing economies lack programs that can be used to regulate supply and then stabilize prices. vii) Agricultural products have low market in industrial production. This reduces the market for surplus output in developing countries. Discovery of new technologies in developed countries reduced the demand for agricultural products. Thus, excess agricultural output cannot be easily disposed off. This forces prices down.
viii)Agricultural products have inelastic demand. This is because most of them are food stuffs. For instance, even if the price for food reduces, the amount of food eaten by an individual almost remains constant. When there is excess supply, disposing it off becomes difficult. On the other hand, food is a necessity, irrespective of the price, people have to consume food. Thus, a reduction in supply forces the price to go up
9.3.3. Effects of price fluctuations Price fluctuations in the agricultural sector lead to changes in farmer’s incomes. This affects their activities in the long run.
The effects include:
• Planning becomes difficult. This is because of fluctuation in farmer’s incomes and government revenue. Implementation of government plans is affected.
• Government revenue is affected. In some developing countries like Rwanda, Agricultural production is a source of revenue to the government.
• Agricultural production is discouraged. Some producers are discouraged and may abandon agricultural production in favor of other sectors. This will result into fluctuations in employment in agricultural sector.
• Modernization of agriculture becomes difficult. This is because it becomes difficult to rely on agricultural revenue to improve agriculture.
• Price fluctuation affects foreign exchange earnings from agricultural exports. This may lead to Balance of Payment (BOP) deficits when prices of exports reduce.
9.3.4. Measures to control price fluctuation
The following can be done to reduce price fluctuations in agricultural sector:
1. Improving storage systems: Stable prices in the agricultural sector can be ensured by improving storage systems. This will help to regulate supply by storing the excess output during periods of bumper harvests. The excess will be used to stabilize prices in periods of scarcity. This practice of storing products accumulated during excess supply and distribute during the period of scarcity is also known as Buffer Stocking
2. Improve transport systems: This facilitates the movement of commodities from areas of plenty to areas of scarcity, quickly and cheaply. This also helps to regulate supply.
3. Diversification of the agricultural sector: This creates a variety of commodities supplied to the market. It also reduces competition among sellers especially in foreign markets.
4. Improvement in technology: Technology reduces dependence on natural conditions. This increases the quality of output which makes it competitive.
5. Processing agricultural products: This adds value to agricultural products and makes them competitive.
6. International commodity agreements: These agreements can be used to stabilize prices on the international market. These help to stabilize prices of agricultural products by regulating production in the member countries.
7. Stabilization process: Prices can be stabilized through establishment of farmers’ associations to regulate supply. These associations may help to fix quotas and regulate supply. Farmers would produce according to the fixed quotas.
8. Price control / Administrative price: Price control refers to the methods that can be used to interfere with the forces of demand and supply in determining prices. Price mechanism is not allowed to influence prices in the market. It can also be called price administration. The following are the methods used to fix/ control prices:
– Maximum price legislation (price ceiling): This is the highest price fixed by the government below the equilibrium point above
which it is illegal to buy or sell the commodity. Sellers and buyers are required by law not to buy or sell above the fixed price. As it is fixed below the equilibrium, consumers are willing and ready to buy more commodities since the prices are affordable. On the other hand, however, sellers are discouraged by the low price. Quantity supplied reduces.
• Minimum price legislation (price floor):
This is the lowest price fixed by the government above the equilibrium point below which it is illegal to buy or sell commodities. For instance, a minimum wage for workers or minimum price set by the government for agricultural products to protect farmers from being cheated by the profit-oriented traders/ middlemen.
• Resale price maintenance: This is where the producer fixes the price of his products up to the retail level i.e. retailers sale at a constant price fixed by the producer.
For instance:
• Prices of Newspapers.
• Prices of Airtime cards.
• Prices of Textbooks etc.
• Rent control: This is where the government intervenes to fix prices of housing facilities especially in urban areas where their demand is always high as a way of protecting consumers (tenants).
• Rationing: This is where the government takes control of the supply channel of a scarce commodity and distributes it to consumers equally at a constant price. It is aimed at ensuring supply of the scarce commodity to all consumers.
• Use of international commodity agreement
9.3.5. Effects of price control
Positive effects:
• Resale price maintenance stabilizes producer’s incomes i.e. whether demand is greater or less than supply, producer prices and incomes remain the same.
• Maximum price controls monopoly power. Monopolists usually cheat buyers by charging high prices. Thus, maximum price legislation will control price increases by monopolists.
• Price controls maintain price stability. Prices are kept constant and this favours consumers. It keeps the real value of their incomes stable.
• Price control protects consumers from being exploited by profit motivated producers. In periods of scarcity, consumers are protected from high prices.
• Minimum wage increases the purchasing power of workers. This improves their general standard of living, aggregate demand and production in general.
• The minimum wage protects workers from exploitation by employers by paying them low wages. Producers usually aim at increasing their profits by reducing total costs.
• Price control protects producers from being under paid by profit motivated middlemen. Traders buy from producers like rural farmers at very low prices.
• Minimum wage maintains industrial peace. It avoids the occurrence of strikes by trade unions when demanding wage increments
Negative effects
• Maximum prices lead to black markets. Commodities are sold to willing buyers at higher prices behind counters. This is because of shortages in the markets.
• Minimum wage legislation may increase the supply of labour by reducing voluntary unemployment and so creates unemployment.
• Maximum prices increase demand creating shortages. When the price is fixed below the equilibrium, supply is discouraged but quantity demanded widens.
• Minimum prices like minimum wages increase the cost of production. This reduces the volume of production. Production becomes expensive through a high wage bill.
Application Activity 9.3
1. Discuss the causes of price fluctuation on agricultural products.
2. Fixing prices is one of the methods used to handle the problem of price fluctuation. Identify any other method can the government use to control prices.
Skills Lab 9
Visit the Sector Agricultural Officer (Agronomist) or any other agricultural officer or invite him as a guest speaker and discuss with him or her, on the causes & effects of price fluctuation to the community, the policies the government can use or has put in place to address the problem of price fluctuation in the agricultural sector in the country. Take notes and make brief presentations.
End of unit 9 assessment:
1. The government should control prices of essential goods, Justify.
2. Explain the factors that limit the success of international commodity agreements
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