The Price Mechanism

• The price mechanism determines the market price. It occurs in a free market economy.
• The economic problem of scarce resources is solved through this mechanism.
• In the price mechanism, the price moves resources to where they are demanded or where there is a shortage, and removes resources from where there is a surplus.
• Rationing function


  When there are scarce resources, price increases due to excess demand. The increase in price discourages demand and therefore rations resources. This is a disincentive.
• Incentive function


  Encourages a change in behaviour of a consumer or producer. E.g. a high price would encourage firms to supply more to the market because it is profitable to do so.
• Signalling function


  The price changes show where resources are needed in the market. A high price signals firms to enter the market because there is profit to be made, however this tells consumers to reduce demand and therefore leave the market.
• The price mechanism is the way in which the basic economic problem is resolved in a market economy.
• Advantages of the price mechanism:

  • allows the consumer to gain sovereignty in the market; they have spending votes which enables them to control what is produced and bought.
  • the free market allows for an efficient allocation of resources
• Disadvantages of the price mechanism:

  • does not consider what the distribution of income is; those with money have power, whilst those without are left out.
  • ignores equality
  • there is under-provision of public and merit goods, which requires government intervention.
• Signalling


  Instigates movement of firms/consumers in and out of the market due to changes in price.
• Incentive


  Changing behaviour of producers/consumers in a market
• Rationing 


  Change in prices ration resources, i.e. control supply or demand