Price mechanism

• The price mechanism is the interaction of supply and demand on a free market that allocates scarce resources amongst competing needs and wants
• Adam Smith referred to the functions of the price mechanism as the 'invisible hand of the market'
• The price mechanism consists of the 3 functions:

  • Rationing
  • Incentive
  • Signaling
• When any of the functions fail to work, market failure can occur
• Rationing


  When the resources are scarce the price goes up. Only the people who can afford to pay, receive the goods. This means that the demand decreases and causes a movement along the demand curve

  
• Incentive


  Encourages producers to increase or decrease output to increase profits

  
• Signalling


  A change in price provides a signal to costumers and producers about where resources are wanted

  
• The price mechanism allows for efficient allocation of resources in a free market therefore there is no need for government intervention
• An advantage of the price mechanism is that consumers have the freedom to choose goods and services based on tastes, preferences, and income
• One of the disadvantages of the price mechanism is that it may create inequality as only those with higher incomes have buying power