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
- 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 & consumers where resources are required (in markets where prices increase) & 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'