7). Price Mechanism

• What is Price Mechanism?


  The price mechanism describes how decisions taken by consumers and firm interact to determine the allocation of scarce resources between competing users.
• Adam Smith: He believed that market equilibrium (allocative efficiency) would be achieved through the operation of an invisible hand.
• Main functions of the Price Mechanism:


  • Rationing – Prices serve to ration scarce resources when market demand outstrips supply. When resources become scarcer the price will rise further. Only those who can afford to pay for them will receive them.
  • Incentives – e.g., when the price of a product rises, quantity supplied increases as businesses respond. Falling prices incentivise reallocation of resources to new markets. 
  • Signalling – Prices adjust to demonstrate where resources are required, and where they are not (when price equilibrium moves, output equilibrium moves with it).
• Factors that affect the price mechanism:


  • Seasonal factors
  • Consumer tastes
  • Government regulations
  • New competitors entering the market
  • Availability of technological advances
  • Changes in the business structure and outsourcing