Contents: 13 sections
Cambridge IGCSE Economics 0455
Syllabus points
- Describe the market system and how it allocates resources.
- Explain the three functions of price: signalling, incentive and rationing.
What is a market?
A market is any arrangement that brings buyers and sellers together to trade a good or service. It does not need to be a physical place, an online marketplace, a stock exchange and a phone call between a farmer and a wholesaler are all markets.
In a market system, nobody plans what gets produced. Resources are allocated by the decisions of millions of separate buyers and sellers, coordinated by prices.
The three basic questions
Every economy must answer three questions, and the market answers all three through price:
| Question | How the market answers it |
|---|---|
| What to produce? | Goods people are willing and able to pay for. Profit guides firms towards them. |
| How to produce? | The cheapest method, because firms compete and lower costs mean higher profit. |
| For whom? | Those willing and able to pay: so income decides who gets what. |
Notice the third answer. The market allocates to those who can pay, not to those who most need. That is an efficient answer and, for many people, an unfair one, which is why governments intervene (2.11).
The three functions of price
This is the core of the topic and the part most often examined.
1. Signalling. Prices carry information. A rising price tells producers that a good is scarce or wanted; a falling price tells them the opposite. Nobody has to collect or publish this information, the price does it automatically.
2. Incentive. Prices reward action. A higher price makes production more profitable, so firms have a reason to supply more and new firms have a reason to enter.
3. Rationing. Prices limit demand. When a good becomes scarce, its price rises and some buyers drop out, so the smaller quantity goes to those willing and able to pay most.
Rising demand → higher price → signals scarcity → incentivises more supply → rations demand → resources move into that market.
That chain is the answer to "how does a market economy allocate resources?" and is worth learning as a sequence.
How resources move between markets
Prices do not just balance one market, they move resources between markets.
If demand for electric cars rises and demand for petrol cars falls, the price of electric cars rises and their producers make more profit. Land, labour and capital are gradually drawn out of petrol car production and into electric car production. Nobody ordered this to happen; the price signal did it.
This is what economists mean by the price mechanism, sometimes called the "invisible hand".
When the market fails
The price mechanism works well but not perfectly. It ignores costs and benefits falling on third parties, provides no public goods, and can allow monopolies to form (2.10). It also answers "for whom" purely by ability to pay. These are the reasons almost every real economy is mixed rather than purely market-based.
Worked example
A drought destroys much of a country's coffee crop.
Supply falls → at the old price there is excess demand → the price rises.
Now trace all three functions:
- Signalling: the higher price tells everyone coffee has become scarce.
- Rationing: some buyers are unwilling to pay the new price and stop buying, so the smaller crop is shared out among those who will.
- Incentive: the higher price makes coffee growing more profitable, so farmers plant more for next season, and resources move into coffee production.
No government decided any of this. That is the point of the example, the market reallocated resources by itself.
Common exam mistakes
- Saying a market must be a physical place.
- Giving only one or two functions of price when the question asks about its role.
- Confusing signalling with incentive. Signalling gives information; incentive gives a reason to act.
- Saying the market allocates to those who need goods. It allocates to those who can pay.
- Describing the price change without explaining the functions.
Exam technique
If asked how the market allocates resources, name all three functions and apply each to the good in the question. Three named functions with an example each is a complete answer.
Use the chain, signal, incentive, ration, in that order, because it mirrors how the process actually happens.
For evaluation questions, the strongest point is usually that the market answers "for whom" by ability to pay, which can be efficient and inequitable at the same time.
Building an answer
4 marks, "Explain how the price mechanism allocates resources."
When demand for a good rises, its price rises, which signals to producers that consumers want more of it.
The higher price also raises profits in that market, giving firms an incentive to move resources in and produce more. Resources therefore shift from less-valued uses towards more-valued ones without anyone directing them.
6 marks, "Analyse what happens in a market when consumer tastes shift towards a product."
Demand shifts right, so at the old price there is excess demand, a shortage.
The shortage rations the good to those willing and able to pay, and price is bid up.
The higher price signals scarcity and gives producers an incentive to expand, so quantity supplied extends along the supply curve.
A new equilibrium settles at higher price and higher quantity, and resources have been reallocated into this market and out of others, all through price, with no central instruction.
Naming signalling, rationing and incentive explicitly is what pushes this into the top band.
Types of market
| Market | What is traded | Example |
|---|---|---|
| Goods market | Physical products | Supermarkets, car dealerships |
| Services market | Intangible work | Haircuts, insurance, tutoring |
| Labour market | Workers' time and skills | Job vacancies and applications |
| Capital market | Funds for investment | Bank loans, share issues |
| Foreign exchange market | Currencies | Buying euros with pounds |
Naming the correct market type is often the first mark in a question, and it costs nothing to learn.
A real case to quote
Face masks, early 2020. Demand rose almost vertically while supply could not respond quickly. Prices rose sharply, which is the rationing function working exactly as theory predicts, and which many people found objectionable, because the same mechanism that allocated masks efficiently also allocated them by ability to pay. It is the clearest available example of the price mechanism being effective and unpopular at the same time.
Check you have it
In a private market system certain goods and services would not be available unless the government intervened. What does this identify in a private market?
More questions on the role of markets in allocating resources →Quick revision
- A market is any arrangement bringing buyers and sellers together.
- The market answers what, how and for whom to produce, through price.
- Signalling: prices carry information about scarcity and demand.
- Incentive: higher prices reward producers for supplying more.
- Rationing: higher prices limit demand when goods are scarce.
- Prices move resources between markets: the price mechanism.
- The market allocates by ability to pay, not by need.