The Price Mechanism (Cambridge (CIE) IGCSE Economics): Revision Note

Understanding the price mechanism

What is the price mechanism?

• The price mechanism is where the forces of demand and supply determine the prices of goods and services in a market economy

  • The price mechanism ensures that scarce resources are allocated efficiently in competitive markets

• Prices act as signals and incentives that help answer the three fundamental economic questions:

1. What to produce?

• Producers observe prices in the market to decide which goods and services are most profitable to supply

  • If the price of electric vehicles rises, it signals strong demand and potential profit

  • In response, firms are incentivised to produce more electric vehicles instead of petrol cars

2. How to produce?

• Firms choose the most cost-effective method of production based on prices of inputs (labour, machinery, raw materials)

  • If wages rise, firms may substitute labour with machines to lower costs

  • If fuel prices fall, they might use more energy-intensive methods

3. For whom to produce?

• Goods and services are produced for those willing and able to pay based on consumer purchasing power

  • If higher-income consumers demand more luxury goods, producers will respond to that market segment

  • This means that income distribution in the economy affects who gets access to goods