1.2.7 Price mechanism

• Price mechanism


  Determines the market price
• Adam Smith called the price mechanism 'the invisible hand of the market'
• Price mechanism in a free market economy

  • Allocates resources
  • Solves the economic problem of scarce resources
• How the price mechanism allocates resources

  1. Moves resources to where they are demanded or where there is a shortage

  2. Removes resources from where there is a surplus
• Functions of the price mechanism

  • Rationing
  • Incentive
  • Signalling
• Rationing function


  1. Price increases due to excess demand

  2. Increase in price discourages demand

  3. Rations resources
• Example of rationing


  • Plane tickets rise as seats are sold, because spaces are running out
  • This is a disincentive to some consumers to purchase the tickets
• Incentive function


  Encourages a change in behaviour of a consumer or producer
• Example of incentive function


  • High price would encourage firms to supply more to the market, because it is more profitable to do so
• Signalling function


  • The price acts as a signal to consumers and new firms entering the market
  • Price changes show where resources are needed in the market
• Example of signalling function


  • High price signals firms to enter the market because it is profitable
  • However, this encourages consumers to reduce demand and therefore leave the market
  • This shifts the demand and supply curves