price-mechanism

Functions of The Price Mechanism

• The price mechanism is the interaction of demand and supply in a free market

  • This interaction determines prices which are the means by which scarce resources are allocated between competing wants/needs

• The price mechanism fulfils three functions in the relationship between buyers and sellers

  • Rationing: prices allocate (ration) scarce resources. When resources become scarcer the price will rise further. Only those who can afford to pay for them will receive them. If there is a surplus then prices fall and more consumers can afford them

  • Signalling: prices provide information to producers and consumers where resources are required (in markets where prices increase) and where they are not (in markets where prices fall)

  • Incentive: when prices for a good/service rise, it incentivises producers to reallocate resources from a less profitable market to this market in order to maximise their profits. Falling prices incentivise reallocation of resources to new markets 

• Adam Smith referred to the functions of the price mechanism as the ‘mystery of the invisible hand’

Price Mechanism at Work in Different Markets

• The price mechanism operates in all markets including local, national and global

Price mechanism in a local market

• Long Island, USA has a rich history of agriculture and many producers set up farm shops selling directly to the public. In recent years, honey consumption has increased

• Due to a change in one of the conditions of demand (most likely change in tastes), the demand for honey in the local market has increased from D₁→D₂ and the price has increased from $15 to $18

  • The higher price serves to ration a valuable product. Those consumers who can afford to purchase it at $18, receive it

  • The higher price incentivises producers to allocate more factors of production to producing honey and this is evident from the extension in supply from Q₁ to Q₂

  • The shift in demand signals to other producers that demand for honey is strong and they should consider entering the market

Price mechanism in a national market

• The T-Shirt market in the UK is highly competitive. In 2018 the price of cotton fell

Price mechanism in a global market

• Cash crops such as wheat, oats, barley, soy, corn, sunflowers etc. can be grown using the same factors of production

  • Many countries export excess crops into the world market

  • Producers use world prices to guide their production decisions

• Farmers in France have been producing corn for many years and the market price is $2/kg. The price of potatoes in global markets has until recently been steady at $2/kg

• Due to a change in one of the conditions of demand (possibly an increase in global population), the demand for potatoes has increased from D₁→D₂ and the price has increased from $2/kg to $3/kg

  • The higher price serves to ration the potatoes. Those consumers who can afford to purchase it for $3, receive it

  • The higher price incentivises producers to allocate more factors of production to producing potatoes and this is evident from the extension in supply from Q₁ to Q₂

  • The shift in global demand signals to producers in France that demand for potatoes is strong and they should consider switching some of their production from corn to potatoes