1.2.7: Price Mechanism

• Function of price: To allocate scarce resources using signalling, incentivising and rationing functions
• Signalling: If price changes because of a change in demand, firms are signalled to change their output level, and makes consumers change how much they will purchase
• Incentivising: Higher prices incentivise producers to increase supply as the profit margins are greater, while lower prices incentivise consumers to increase demand as they can get the same utility for a lower price
• Rationing: If there is excess demand, price increases so only those who are most willing and able to pay will buy
• Why signalling may not work: If there are externalities, maximum or minimum prices, if price set is not the equilibrium price
• Incentives may not work for production of public goods, causing market failure if they are not provided
• Rationing: Might not work if the government sets the price