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.
The Price mechanism describes the means by which millions of decisions taken by consumers and businesses interact to determine the allocation of scarce resources between competing uses.
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.
Main functions of the price mechanism
1. 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.
2. Signalling function
- Prices perform a signaling 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 stronger 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.
3. Incentive function
- Through choices, consumers send information to producers about their changing nature of needs and want.
One important feature of a free-market system is that decision-making is decentralized, 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 a significant intervention in market prices and state-ownership of key industries.