A Level Economics AQA Practice Exam

What defines the incentive function of prices?

1. Prices have no effect on supply

2. Higher prices discourage consumer demand

3. Lower prices increase profit margins

4. Prices influence changes in supply and demand behavior

The correct answer is: Prices influence changes in supply and demand behavior

The incentive function of prices is fundamentally tied to how they influence the behavior of consumers and producers in the market. When prices change, they send signals to both sides of the market. For consumers, a rise in prices typically indicates that a good or service is becoming more expensive, which can lead to a decrease in quantity demanded as people seek alternatives or reduce their consumption. Conversely, a fall in prices makes goods more affordable, likely increasing demand. On the production side, higher prices can incentivize producers to supply more of a good, as the potential for increased revenue makes it worthwhile to allocate more resources to its production. This interaction shapes the market equilibrium through the forces of supply and demand, continuously adjusting as prices fluctuate. Consequently, prices play a crucial role in guiding economic activity by influencing the decisions of both consumers and producers, thereby defining their incentive function.