The Functions of the Price Mechanism (Cambridge (CIE) A Level Economics): Revision Note

The 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

Explaining each function

Rationing 

• When resources become scarce, the price will rise. 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

  • E.g The price of plane tickets might rise as seats are sold, because spaces are running out. This is a disincentive to some consumers to purchase the tickets, which rations the tickets

Incentive

• The incentive function encourages producers to increase or decrease output to increase profits

  • When prices for a good/service rise, it incentivises producers to reallocate resources from a less profitable market in order to maximise their profits

  • Falling prices incentivise reallocation of resources to new markets

Signalling

• A change in price provides a signal to consumers and producers about where resources are wanted (markets with increasing prices) and where they are not (markets with decreasing prices)

• This allows consumers and producers to make informed decisions

  • High prices signals to a producer to produce more of that good/service and would signal to other producers to enter the market

  • A falling price signals to consumers to purchase more of a product

The price mechanism in action

• 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 been steady at $2/kg

• Due to a change in one of the determinants 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

What happens?

• 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