What are Price Mechanisms?
- Changes in price, or the price mechanisms, determine how scarce resources are allocated in an economy.
- As price changes, the free market corrects itself using a system of feedback consisting of signals and incentives.
The Three Functions of Price
1: Signaling Function of Prices
- Prices are set by the actions of consumers and producers in a market and so they reflect the current circumstances in a market, acting as a signal to those in the market to act in some way.
- Prices are important for signaling information to consumers and producers, as they tend to base their decisions on the price, or set it differently depending on the situation.
2: The Incentive Function of Prices
- Consumers: Lower prices give consumers an incentive to buy more of a good.
- Higher prices will act as a disincentive, since the utility in relation to the money spent falls.
3: Rationing
- Rationing refers to the controlled distribution of resources.
- Rationing is necessary at any time when goods and resources are scarce.
- Price is typically the best rationing function.
- Price helps to allocate and ration scarce resources.
- If the demand for a good increases, then producers will respond to the resulting increase in price by allocating more resources to supply more of that good.
- It is price that controls resource allocation, as in a free market there is no central planning agency to control rationing of resources.
- However, during times of severe scarcity where individuals are willing but not able to purchase bare necessities due to dramatic shortages, the government may step in.
- In World War II for example, the government began rationing many goods in the UK.