the-market-price-mechanism

Functions of the Price Mechanism

• The price mechanism is the interaction of demand and supply in a market economy 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 fulfils three functions in the relationship between buyers and sellers which include rationing, incentivising and signalling

• When any of these functions breaks down, market failure can occur

Functions of the Price Mechanism

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

Diagram analysis

• 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

Diagram analysis

• Due to a change in one of the conditions of supply (a decrease in costs of production), the supply of T-shirts in the UK has increased from S₁→S₂ and the price has fallen from P₁ to P₂

  • The lower price increases the number of consumers who can access this product. It is rationed more widely as there is an excess in supply 

  • The lower price incentivises consumers to purchase more T-shirts and this is evident from the increase in demand from Q₁ to Q₂

  • The shift in supply signals to other producers that there is excess supply and they should consider leaving the market

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

Diagram analysis

• 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

Advantages and Disadvantages of the Price Mechanism

• The price mechanism allows for efficient allocation of resources in a free market

  • There is no need for government intervention or planning, as price signals incentive to allocate more or less resources

Evaluating the Price Mechanism