2.3.3 Functions of the price mechanism Notes

1. When markets operate competitively, the demand and supply determine the equilibrium price and quantity.
2. This system in which the interactions of consumers and producers determine the prices through forces of demand and supply is referred to as the price mechanism.

The price mechanism is responsible for two functions in an economy:

1. Resource allocation: assigning the factors of production to specific economic activities to efficiently produce goods and services.
2. Rationing: the controlled distribution of the scarce resources, goods, and services.

Resource allocation

The price mechanism affects the resource allocation within industries and countries:

1. Producers sell only the goods (or services) and quantity of the goods that consumers are willing and able to buy.
2. Consumers buy only the goods (or services) and quantity of the goods that the producers are willing and able to supply.

This equality in the buying and selling choices allocates resources and determines what is being produced and how much:

1. Firms will only use the resources that consumers are willing and able to pay for.
2. Through this mechanism, a free market economy answer the question what to produce? (and how much).

In a nutshell, prices function as signals and incentives that determine the resource allocation.

Signalling function of prices

The signalling function of prices communicates important information to buyers and sellers:

1. Excess demand (shortage) (too many buyers and not enough goods) leads to higher prices, signalling producers to increase supply.
2. Excess supply (surplus) (too many goods and not enough buyers) causes lower prices, signalling producers to reduce supply.

Incentive function of prices

The incentive function of prices guides consumer and producers by providing them motivation to act in their best self-interest:

1. Producers respond to price changes based on the potential for profit, following the law of supply:
   1. If the price of a good increases, producers allocate more resources to its production to maximize profits.
   2. Conversely, falling prices may lead to a reduction in supply as producing the good becomes less profitable.
2. Consumers react to price changes according to the law of demand:
   1. A price drop increases the quantity demanded as the product becomes more affordable.

• If prices rise, consumers reduce their consumption or seek substitutes.

As producers and consumers are incentivised to change their behaviour due to the information signalled by prices, this results in a re-allocation of resources.

Example

The figure above shows the market for good $X$. Initially the market is at equilibrium on point $a$ with price $P_1$ and quantity $Q_1$.

1. Something causes the demand to increase, shifting the curve to the right (e.g. consumer preferences shift towards good $X$) from $D_1$ to $D_2$
2. This increase in demand causes an excess demand from $Q_2$ to $Q_1$ and thus upward pressure on price drives the prices up till $P_2$.

Hence, now the price acts as a signal and incentive to both producers and consumers

1. The higher price signals to producers that a shortage has occurred, and it incentivizes them to increase their quantity supplied since higher prices are more profitable
2. Hence, the quantity supplied increases from $Q_1$ to $Q_3$ for producers
3. However, the higher price also signals to consumers that good $X$ is more expensive and incentivizes them to purchase less of the good.
4. Therefore the quantity demanded decreases from $Q_2$ to $Q_3$

Hence, a new equilibrium is reached at point $c$, and resources have been re-allocated:

1. A higher quantity of good $X$ was being made overall.
2. Now, there is more allocation of resources to the production of good $X$.

Rationing

Who gets how much of the good or service is completely determined by price (price rationing)

• People who are willing and able to buy the good or service at the price determined by the forces of supply and demand will get it.
• People who are not willing and able to buy it, will not.

Hence, the price mechanism on its own determines if a consumer gets a good or service, dividing the available output amongst those who are willing and able.