Price Mechanism
Price
Mechanism: It is a
system which allocates scarce resources for the production of goods and services according
to the forces of demand and supply.
The price mechanism is the concept
that the free market, when left to its own devices, will formulate fair prices
of the goods or services on its own by the natural laws of supply and demand.
It is the process by which changes in prices
guide and shape changes in the value and
types of the goods and services that are produced. The price mechanism will
determine: “WHAT IS PRODUCED, HOW MUCH IS PRODUCED AND FOR WHOM A GOOD OR
SERVICE IS PRODUCED FOR.”
The shoe market is an example
of a competitive market where a number of firms compete to meet the demand for
certain products or services. Two kinds of participants operate in it: those
who have money and want shoes (demanders) and those with shoes who want money (suppliers).
The ceteris paribus assumption applies in drawing the demand curve1 and
the supply curve.2 If any one of these variables should change, the demand
curve and the supply curve for shoes would be altered.
Both producers and consumers
base their respective production and consumption plans on the prevailing market
price. When consumers pay a price for a commodity, they motivate the producer
of that commodity and hence more of the same is produced and vice versa. The
price paid becomes a vote for more production. Thus resources are channeled
there.
Suppose consumers decide that
they want to spend more on shoes. More consumers show up at stores hoping to
buy shoes. The stores see the higher demand, raise their prices, and also order
more shoes from producers. Higher profits from making shoes induce firms to
expand production. Higher prices for shoes curb demand. Thus the system returns
to a stable point with more production and purchase of shoes, and less
production and purchase of other goods. Thus “prices” act as a “mechanism” that
guides the allocation of productive resources--machines and workers--to
different sectors of the economy.
The plans of the buyers and the
plans of the sellers are balanced at a point, at which a transaction can take
place, by the operation of the price mechanism (market mechanism or Invisible
Hand). This balancing of forces, this perpetual tendency toward equilibrium, is
the Law of Supply and Demand.
The concept of the equilibrium
is of the utmost importance in economic theory. Equilibrium is a state of rest,
when there is no reason for anything to change unless disturbed by an outside
shock. At the equilibrium price quantity supplied equals the quantity demanded.
QS =
QD is
the equilibrium condition.
If intended
supply > intended demand, price will fall
If intended
supply < intended demand, price will rise
If intended
supply = intended demand (equilibrium)
The
Functions of the Price Mechanism
The Rationing Function
When consumers and firms respond
to the information and incentives provided by prices, scarce resources are
rationed between competing uses. Prices function as a mechanism for allocation.
For example, say the price for a pair of shoes is ₩40,000 and say this is
well below the market clearing price. In a free market situation prices will
rise to eliminate this disequilibrium. This illustrates the rationing function.
The Signaling
Function: Prices must convey
sufficient information to all traders in the market for their economic activities
and plans to be coordinated. The signaling function of the price mechanism can
be illustrated by looking at the market for trainers. Assume that some
advertising campaign has recently made such goods popular thus shifting the
demand curve to the right.
The initial shift to the right
would act as a signal for other firms in other markets.
An incentive: is something that motivates a producer or
consumer to follow a course of action or to change behaviour. Higher prices
provide an incentive to producers
to supply more, or to enter the market, because they provide the possibility or
more revenue
and increased profits.
Example In response to an incentive signaled by
the high price, firms would shift their resources into the production of
training shoes.
The Allocative Function
The price mechanism will also
ensure that goods will be allocated efficiently. If prices are set above
equilibrium, suppliers will find themselves with a surplus of stock. Prices
will fall to clear the market and allocate resources efficiently.