Functions of Price Mechanism

• Signalling function - Market prices will adjust to demonstrate where resources are required, and where they are not. E.g. Prices rise to reflect shortages and fall to reflect surpluses.
• Incentive function - Consumers are able to send important information to producers about the changing nature of their needs and wants throught their expression of preferences for them to adjust and satisfy customers' wants. E.g. When demand is high, higher market prices act as an incentive for producers to raise output, and vice versa.
• Rationing function - This function rations out the goods produced according to the willingness and ability to pay. E.g. Buyers who desire the good and can afford to pay the price obtain the item and those who cannot, go without.
• The price mechanism allocates scarce resources by performing three functions:

  • Signalling function
  • Incentive function
  • Rationing function
• The price mechanism is vital to answer the fundamental questions of resource allocation:

  1. What to produce
  2. How much to produce
  3. For whom to produce for