CHAPTER 5C

THE FUNCTIONS OF THE PRICE MECHANISM

The interaction of buyers and sellers in free markets enables goods, services, and
resources to be allocated prices. Relative prices, and changes in price, reflect the
forces of demand and supply and help solve the economic problem. Resources move
towards where they are in the shortest supply, relative to demand, and away from
where they are least demanded.

The rationing function of the price mechanism

As resources are scarce and finite, demand exceeds supply and prices are driven up.
The effect of such a price rise is to discourage demand and conserve resources. The
greater the scarcity, the higher the price and the more the resource is rationed. This
can be seen in the market for oil. As oil slowly runs out, its price will rise, and this
discourages demand leading to more oil being conserved than at lower prices. The
rationing function of a rise in price enables the good/service to be rationed out to
those who can afford to pay. This is associated with a contraction of demand along
the demand curve.

The signalling function of the price mechanism

Price changes send contrasting messages to consumers and producers about whether
to enter or leave a market. Rising prices give a signal to consumers to reduce demand
or withdraw from a market completely, and they give a signal to potential producers
to enter a market. Conversely, falling prices give a positive message to consumers to
enter a market while sending a negative signal to producers to leave a market. For
example, a rise in the market price of 'smart' phones sends a signal to potential
manufacturers to enter this market, and perhaps leave another one. Similarly, the
provision of 'free' healthcare may signal to 'consumers' that they can pay a visit to
their doctor for any minor ailment, while potential private healthcare providers will
be deterred from entering the market. In terms of the labour market, a rise in the
wage rate, which is the price of labour, provides a signal to the unemployed to join
the labour market. The signalling function is associated with shifts in demand and
supply curves.

The incentive function of the price mechanism

An incentive is something that motivates a producer or consumer to follow a course

of action or to change behaviour. Higher prices provide an incentive to existing
producers to supply more because they provide the possibility of more revenue and
increased profits. The incentive function of a price rise is associated with an
extension of supply along the existing supply curve.

Diagrammatic explanation

A market starts with a stable equilibrium, where demand equals supply.

A supply shock reduces supply at each and every price. This creates an excess of
demand at the existing price.

The price is now forced up to a new price (P1) where the market clears.
At the new price, demand and supply are brought into equilibrium through a
contraction of demand (the rationing effect) and an extension of supply (the incentive
effect).

In the long run, the higher price sends out signals, either for existing firms to
introduce better production methods or by new firms entering the market. This causes
the supply curve to shift to the right. Eventually, price may return to its existing level.

In conclusion, the price mechanism is said to work effectively through a combination

of rationing, incentives and signals.