Question

a) Explain how markets can work as a decentralized coordination mechanism linking buyers and sellers. In the process, make sure you…

i) Explain how prices can both provide information and motivation to buyers and sellers.

ii) Explain how markets differ from central planning

b) What if prices send the wrong signal, however?

i) Explain the concept of externality and why the existence of externalities might be problematic.

ii) Give one example of an externality, explaining how it makes the price diverge from its proper level.

Answer 1

a) Market mechanism is based on price signals . Price provides effective information regarding quantity demanded and supplied . It is the mechanism of invisible hand that controlls the market . Lower price motivates buyers to demand more and higher price motivates producers to produce and supply more . The market comes to equilibrium with adjustment . When the price is high there will be excess supply and shortage of demand . So the price tends to fall down to equilibrium where the market clears . It is an automatic system and requires no central planning . Central planning is the approach where the bureaucracy allocates the resources . The limited resources of the economy are owned by the central government , whereas in market system the resources are allocated through interactions by private entities .