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Price mechanism

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Price mechanism refers to the process that consumers as well as businesses depend on when
allocating the prices of scarce resources in the market. The major role of price mechanism is the
signaling function (McConnell, Bruce and Flynn, 2012). The signaling function of price
mechanism can be demonstrated when resources are needed and also when they are not needed.
The constant fluctuations of prices in the market reflect the surpluses or scarcities that exist in
the markets (Samuelson and Marks 2003). If there is a price increase in the market it means that
there is shortage in the market and the increase in prices provides a signal to suppliers that the
market needs more supplies and a reduction in prices provides a signal to the supplies to reduce
production (Krugman, Wells and Graddy 2006).
1a) The prices and production of oil anywhere in the world follow a similar pattern just like in all
other economic cases of production and pricing where increased production leads to reduced
prices while a reduction in quantities produced leads to an increase in prices (Mankiw and Taylor

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In 1974, the production of oil was increasing at an increasing rate while the prices were slightly
below US$10 a barrel. The same trend followed until 1980 when the production of oil rigs
increased to 4400 from 1800 in 1979 representing an increase of about 144% while the prices of
oil increased to 37 per barrel from about US$9 a barrel in 1979 representing an increase of 311%
(Melvin & Boyes 2002). The major reason why the US market experienced parallel increase in
both oil prices as well as in the number of oil rigs was mainly because of state regulation of oil
prices. The regulation of oil prices by the US government was prompted by the need to maintain
low oil prices in the country.
In 1983, the trend reveals that there was a large drop in the number of rigs in the US. From a
high of 4400 rigs in the year 1980 to 1750 in 1983. The Prices also dropped from US$37 to about
US$28. However, the trend changed as the production decreased the prices increased. In 1991
the prices increased sharply to 31 while the number of rigs dropped to 1000 in the same year.
From the year 1991 to 1997, the oil prices and the number of rigs have fluctuated inversely. The
decrease in the number of rigs which meant reduced oil production resulted in shortage of oil in
the US market hence the oil prices increased (Parkin, Powell and Matthews 2012). On the other
hand an increase in the number of wells flooded the market with oversupply of oil hence the
prices reduced as oil was available always and in there was no scarcity of the product in the
market (Melvin & Boyes 2002)
1b) In a free market economy, the prices of goods are regulated by the market. When the price
increases more goods are supplied and the demand decreases hence prices decrease.

Economics 3

(Sullivan & Sheffrin 2003)
To stabilize the oil prizes at Equilibrium that is at 60 (between 55 and 65) Saudi Arabia would
move either to increase or decrease the quantity of oil supplied in the market. If the price
decreases to 55 due to increased supply of Q3 to S1, the Saudi government would decrease the
supply to Q2 increasing the demand to D hence the price increases back to 60. If the price of oil
increase to 65 due to increased demand (D1) that could have been occasioned by the reduced
supply to S2 (Q1). Saudi would increase the supply of oil in the market hence the supply would
move from S2 to S and the price would settle back to 60 (Robert 2008).
1c) Price control means that the government sets a price ceiling and floor price for the entire
price controlled products. The products are subjected to a maximum and minimum price
chargeable. The market should be left alone to regulate itself. Between the years 1900 to 1970s,
the US government made efforts to control oil prices in the country and the result was that the

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incentive for suppliers to produce more oil was grossly compromised and the growth of oil rigs
was at its lowest. The controlled oil prices were at times higher than the average global oil
prices (WTRG Economics 2011). Lately, the oil market has been left to find its own equilibrium
and the prices are much lower than when the prices were under the control of the government
(Varian 2006)
The success of the Saudi government to influence the price of oil in the market can only succeed
if the market is ideal and there is no external influence other than the input from Saudi only.
However, the rise of other oil producing countries has greatly watered down the possibility of
Saudi government influencing the oil price. Most oil producing countries are eager to supply
maximum levels of their capacity in an effort to maximize oil revenues. These quantities reduce
the oil market prices as the market is oversupplied hence the demand is low.
Other factors that would make it difficult for government intervention in Saudi government or
any nation to influence the global oil market prices is the high industrialization levels that has
been witnessed in China. The huge demand for energy in China’s industrial market has prompted
most oil producing countries to produce maximum capacity. The level of production that the
global market can sustain is slightly less than the current total global production. These results in
more supply of oil in the market than the demand hence the prices of oil continue to decrease
despite Saudi’s government intervention effort to influence the market prices.
The major advantages of price control are that they are intended to protect the consumers from
exploitation by rogue traders. For example, in the banking sector, charging high interest rates on
desperate citizens aggravates the hard economic situation for surviving citizens hence the
maximum interest charges are meant to protect the citizens but the controls interfere with the free
market regulatory systems. For example, when the a government sets the maximum rent

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chargeable in a country the supply of houses would decrease and the demand for the houses
would certainly increase hence the black market for houses would certainly increase the rents
chargeable. The major advantage of free market economy is that the market promotes
production, sale of goods and encourages specialization. A free market economy allows free
relationship between the suppliers and consumers to dictate the market prices. Lack of
government intervention also allows different market freedoms and market efficiency in pricing.
Free market encourages innovation and provides a wide range of consumer products.
To conclude, government intervention through the setting of price ceilings creates shortages
while the setting of minimum prices creates surpluses as the demand would increase and the
supply would decrease. When the government sets its prices below the equilibrium price
shortages would occur while if it sets it above the equilibrium price then surpluses would
certainly occur as the demand would decrease due to increased prices and the supply would
increase due to increased prices..

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Krugman, P., Wells, R. and Graddy, K., 2006, Economics. European edition. New York;
Basingstoke: Chapters 23, 28 and 31.Worth Publishers.
Mankiw, N. G. and Taylor, M., 2011, Economics. Thomson Learning: Chapters 28, 33 and 36.
McConnell, C., Bruce, s. and Flynn, S., 2012, Economics: Principles, problems and policies,
19th Ed, New York: McGraw-Hill/Irwin;
Melvin & Boyes, 2002, Microeconomics, 5th ed. Houghton Mifflin.
Parkin, M., Powell, M. and Matthews, K., 2012, Economics, 8th European Edition: Chapters 21,
Robert, F., 2008, Microeconomics and Behavior (7th ed.) McGraw-Hill
Samuelson, W and Marks, S., 2003, Managerial Economics 4th ed. page 35. Wiley
Sullivan, A. & Sheffrin, S.M., 2003, Economics: Principles in action. Upper Saddle River, New
Jersey 07458: p.111. Pearson Prentice Hall.
Varian, H., 2006, Intermediate Microeconomics, Seventh Edition, W.W Norton & Company:
WTRG Economics, 2011, Oil Price History and Analysis, Energy Economist Newsletter
retrieved [Online] (updated 2011)

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