Price Mechanism
A-level Economics
The Role of prices in the market
Definition
'The price mechanism is responsible for the allocation of resources in a free market economy. The decisions of consumers and producers are all responsible for how the price mechanism work through demand and supply.'
Prices play 3 important roles in a market economy. Rationing, Signalling and Incentivising.
Rationing: this describes the role of prices when resources are particularly scarce. When they become scarcer, then prices must rise to ration off excess demand. This is why precious metals like gold and platinum are so expensive.
Signalling: this refers to how prices encourage people to enter or leave a market. The signalling function provides information to consumers and producers about the market. If prices rise, what happens? Producers might want to enter the market. Why? Because prices tell the producer that there is probably growing demand there and more money-making opportunities. Some consumers might want to leave the market. Why? Because of the law of demand. Consumers demand less at higher prices.
Incentivising: this is when a producer or consumer is motivated to follow a course of action. For example, when prices rise the producer is incentivised to increase their production, because it is possible that their revenue and profit will increase.
Diagrams:
This is the rationing and incentive function of prices. A short-term increase in demand has created an excess supply of Q1Q2. This incentivises producers to produce more and make more money, because there is too much demand for their current level of stock. They gradually increase the price until they reach P2 (D=S). [They keep increasing the price until all of the excess demand is rationed off.]
The above diagram shows the signalling function of prices. Demand has increased, creating a new equilibrium at a higher price level than before. It sends a informative signals to producers that something good is probably happening in this market. New producers enter the market or existing producers expand their stock of capital goods and this increases the level of supply from S1 to S2. Sellers have responded to the signal of higher prices and acted on their opportunities.
What have we learned?
We have learned about the price mechanism its 3 core functions.
We have learned about the effects of prices on markets and how it ties in with demand and supply diagrams.
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