Explaining the Price Mechanism

The price mechanism is the means by which decisions of consumers and businesses interact to determine the allocation of resources.

The free-market price mechanism clearly does NOT ensure an equitable distribution of resources and can lead to market failure.

Changes in market prices

Changes in market price act as a signal about how scarce resources should be allocated.

A rise in price encourages producers to switch into making that good but encourages consumers to use an alternative substitute product (therefore rationing the product).

A fall in price leads to an extension of demand but makes it less profitable for a business to supply the good or service affected.

What are the main functions of the price mechanism?

1. Signalling function

• Prices perform a signalling function – i.e. they adjust to demonstrate where resources are required.
• Prices rise and fall to reflect scarcities and surpluses.
  • If prices are rising because of high demand from consumers, this is a signal to suppliers to expand production to meet the higher demand.
  • If there is excess supply in a market, the price mechanism will help to eliminate a surplus of a good by allowing the market price to fall.

  2. Incentive function

  • Through choices consumers send information to producers about their changing nature of needs and wants.

  One important feature of a free-market system is that decision-making is decentralised, i.e. there is no single body responsible for deciding what to produce and in what quantities.

  This is in contrast to a planned (state-controlled) economic system where there is significant intervention in market prices and state-ownership of key industries.

  3. Rationing function

  • Prices ration scarce resources when demand outstrips supply.
  • When there is a shortage, price is bid up – leaving only those with willingness and ability to pay to buy.
  Price Mechanism - Shifts in and Movements along Curves
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