Price Mechanism

Price mechanism is the system in a market economy whereby changes in price in response to
changes in demand and supply have the effect of making demand equal to supply. In a free market,
consumers and firms are free to make their own economic decisions on what to consume and
produce based on their self interests. The demand and supply decisions of consumers and firms are
then transmitted to each other through their effect on prices: through the price mechanism.
This essay seeks to examine the workings of the price mechanism and how changes in price act as
both signals and incentives for the consumers and producer to change their demand and supply
respectively.
If consumers decide they want more of a good or if producers decide to cut back supply!, demand
will exceed supply. The resulting shortage will cause the price of the good to rise. This will act as an
incentive to producers to supply more, since production will now be more profitable. "t the same
time it will discourage consumers from buying so much. Price will continue rising until the shortage
has thereby been eliminated, equating demand and supply.
If, on the other hand, consumers decide they want less of a good or if producers decide to produce
more!, supply will exceed demand. The resulting surplus will cause the price of the good to fall.
This will act as a disincentive to producers, who will supply less, since production will now be less
profitable. It will encourage consumers to buy more. Price will continue falling until the surplus has
thereby been eliminated, equating demand and supply.
This price, where demand equals supply, is called the equilibrium price. #y equilibrium we mean a
point of balance or a point of rest: in other words, a point towards which there is a tendency to
move.
The same analysis can be applied to labour and exchange rate markets.
" rise in demand is signalled by a rise in price. This then acts as an incentive for supply to rise.
$hat in effect is happening is that the high price of these goods relative to their costs of production
is signalling that consumers are willing to see resources diverted from other uses. This is %ust what
firms do. They divert resources from goods with lower prices relative to costs and hence lower
profits! to those goods that are more profitable. " fall in demand is signalled by a fall in price. This
then acts as an incentive for supply to fall. The goods are now less profitable to produce. " change
in supply. " rise in supply is signalled by a fall in price. This then acts as an incentive for demand to
rise. " fall in supply is signalled by a rise in price. This then acts as an incentive for demand to fall.
&arket will ad%ust so as to equate demand and supply.
'ven though all individuals are merely looking to their own self(interest in the free(market
economy, they are in fact being encouraged to respond to the wishes of others through the incentive
of the price mechanism.
The fact that a free(market economy functions automatically is one of its ma%or advantages. There is
no need for costly and complex bureaucracies to coordinate economic decisions. The economy can
respond quickly to changing demand and supply conditions. $hen markets are highly competitive,
no one has great power. )ompetition between firms keeps prices down and acts as an incentive to
firms to become more efficient. The more firms there are competing, the more responsive they
will be to consumer wishes. The more efficiently firms can combine their factors of production, the
more profit they will make. The more efficiently workers work, the more secure will be their %obs
and the higher their wages. The more carefully consumers decide what to buy, the greater the value
for money they will receive. Thus people pursuing their own self(interest through buying and
selling in competitive markets helps to minimise the central economic problem of scarcity, by
encouraging the efficient use of the nation*s resources in line with consumer wishes. +rom this type
of argument, the following conclusion is often drawn by defenders of the free market: ,The pursuit
of private gain results in the social good.* This claim is the sub%ect of much debate and has profound
moral implications see Threshold )oncept - below!. In practice, however, markets do not achieve
maximum efficiency in the allocation of scarce resources, and govern(
ments feel it necessary to intervene to rectify this and other problems of the free market. The
problems of a free market are as follows:
. )ompetition between firms is often limited. " few giant firms may dominate an industry. In these
cases they may charge high prices and make large profits. /ather than merely responding to
consumer wishes, they may attempt to persuade consumers by advertising. )on( sumers are
particularly susceptible to advertisements for products that are unfamiliar to them.
. 0ack of competition and high profits may remove the incentive for firms to be efficient.
. Power and property may be unequally distributed. Those who have power and1or property e.g. big
business, unions and landlords! will gain at the expense of those without power and property.
. The practices of some firms may be socially undesir able. +or example, a chemical works may
pollute the environment.
2eterminants of 2emand

Price Mechanism

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Price mechanism is the system in a market economy whereby changes in price in response to

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