1.2.7 - Price mechanism

• Price mechanism is the system of resources allocation based on the free market movement of prices, dertermined by the demand and supply curve.
• 3 functions of the price mechanism:

  • Rationing
  • incentive
  • signalling
• The rationing function: The price system is a way of rationing goods because when price increases, some people will no longer be able to afford to buy the product and others may no longer have the desire the buy the good. The limited resources can be rationed and allocated to the people who are able to afford them and those who value them most highly.
• The signalling function: The price mechanism acts as a signal where resources should be used. When prices rise, producers move resources into the manufacture of that product. The change in price indicates to suppliers and consumers that market conditions have changed so they should change the quantity bought and sold- when price equilibrium moves, output equilibrium moves with it.
• The incentive function: It acts as an incentive for people to work hard. Buyers realise that the more money they have, they are able to buy more products. Suppliers realise that if they produce more of the goods, they will make more money. Also, low prices act as an incentive for consumers to buy more of a good and high prices act as an incentive to suppliers to sell more of a good. The price mechanism encourages people to behave a certain way