The working of the price mechanism in a free-market economy refers to which one of the following?
- A.The interplay of the forces of demand and supply
- B.Determination of the inflation rate in the economy
- C.Determination of the economy's propensity to consume
- D.Determination of the economy's full employment output
Correct answer
Explanation
The correct answer is A, The interplay of the forces of demand and supply. In a free market, prices are set by buyers and sellers, not by the government.
The price mechanism is how a market economy answers the basic questions of what to produce, how much and for whom. When demand for a good rises faster than supply, its price goes up; this signals producers to make more and buyers to cut back, until a new equilibrium price is reached where the quantity demanded equals the quantity supplied. Adam Smith called this self-correcting process the invisible hand. In a planned economy, by contrast, a central authority fixes prices and output.
B, the inflation rate, is the change in the general price level, a macroeconomic measure and not the mechanism itself. C, the propensity to consume, is a Keynesian idea about how income is split between spending and saving. D, full-employment output, concerns the economy's total capacity, not the pricing of individual goods.
Exam tip: price mechanism = demand + supply deciding price; Adam Smith's invisible hand; planned economies replace it with state decisions.
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