The price mechanism

In solving the 3 basic problems of an

economy
 Meaning

• A system where price acts as automatic

signals which coordinate the actions of
individual decision making units

• Applicable in capitalist economies

 Types

• Price mechanism under free market

economy
• Price mechanism under controlled or
command economy
 Difference
• Adjustment in prices • Administered price
through demand mechanism to achieve pre
supply interaction specified economic targets
• Relevant for capitalist • Relevant for socialistic
economy economy
• Solves economic • Solves economic
problems through problems through
market forces planning with positive
government intervention
 FUNCTIONS OF PRICE
MECHANISM
• The level of economic activities
• Co-ordination of economic decisions
• Guiding force to consumers and producers
• Determination of factor income
• Allocation of resources
• Determination of savings
• Flexibility of the economy
Solutions to the basic problems
What to 1. Commodities with positive prices
produce? 2. More of Commodities with relatively
higher prices

How to 1. Production technique chosen

produce? according to factor prices
2. Employing factors which are relatively
abundant and also cheaper

For whom to 1. Depends on purchasing power

produce? 2. Factor income
 Conditions for free price
mechanism
• Output exceeds self consumption
• Technology developed enough
• Facilities of exchange
• Existence of competition
• Mobility of resources
• Demand reflecting need and cost reflecting
sacrifice
• Non economic conditions
 Evaluation: advantages

• No intervention: self enforcing

• Preservation of individual freedom
• Promotes social welfare
• Solves economic problems
 Evaluation: limitations
• Creation of monopoly
• Inequality in the standard of living
• Problem of economic development
• Problem of business cycle
• Production of public utilities neglected
 Role of government
• Prices are administered
• Decisions of production , consumption and
distribution are controlled
• Allocation of factors and their income
decisions are controlled
• Direct and indirect role of government in
solving economic problems
Which mechanism is suitable for
a mixed economy