The Price Mechanism

The Price Mechanism - The means by which millions of decisions taken by consumers and businesses interact to determine the allocation of scarce resources between competing uses. In a free market economy, resources are allocated through the price mechanism.

The price mechanism achieves this through the following three functions:

Rationing -

• The fundamental economic problem is one of scarcity; infinite wants, but finite resources.
• The price mechanism resolves this by rationing according to ability and willingness to pay, where demand is higher than supply, price will rise, eliminating some consumers from the market altogether, while other consumers will buy less.If there is excess supply, then price will fall, resulting in demand extending and eliminating the surplus.

Signalling -

• The price mechanism also acts as a signalling mechanism to both consumers and producers; both groups react to price changes by adjusting their consumption and production.
• Prices rise and fall to reflect scarcities and surpluses; if prices are rising because of high demand from consumers, this is a signal to suppliers to expand production to meet the higher demand, if there is excess supply in the market the price mechanism will help to eliminate a surplus of a good by allowing the market price to fall.

Incentivising -

• Consumers and producers want to maximise their economic wellbeing. This means that lower prices will encourage consumers to buy more, as they will increase their total utility by switching some spending to buy goods whose price has fallen. Producers, who seek to maximise profit, will be willing to supply more when…