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Functions of the Price Mechanism

Author: Geoff Riley  Last updated: Sunday 23 September, 2012

Introduction

Adam Smith’s Invisible Hand

Adam Smith, one of the Founding Fathers of economics described the “invisible hand of the price mechanism” in which the hidden-hand of the market operating in a competitive market through the pursuit of self-interest allocated resources in society’s best interest.

This remains a view held by free-market economists who believe in the virtues of an economy with minimal government intervention.

The price mechanism describes the means by which millions of decisions taken by consumers and businesses interact to determine the allocation of scarce resources between competing uses

The price mechanism plays three important functions in a market:

1/ Signalling function

  • Prices perform a signalling function – they adjust to demonstrate where resources are required, and where they are not
  • Prices rise and fall to reflect scarcities and surpluses
  • If prices are rising because of high demand from consumers, this is a signal to suppliers to expand production to meet the higher demand
  • If there is excess supply in the market the price mechanism will help to eliminate a surplus of a good by allowing the market price to fall.

price mechanism

In the example on the right, an increase in market supply causes a fall in the relative prices of digital cameras and prompts an expansion along the market demand curve

2/ Transmission of preferences

  • Through their choices consumers send information to producers about the changing nature of needs and wants
  • Higher prices act as an incentive to raise output because the supplier stands to make a better profit.
  • When demand is weaker in a recession then supply contracts as producers cut back on output.

One of the features of a market economy system is that decision-making is decentralised i.e. there is no single body responsible for deciding what is to be produced and in what quantities. This is a remarkable feature of an organic market system.

3/ Rationing function

  • Prices serve to ration scarce resources when demand in a market outstrips supply.
  • When there is a shortage, the price is bid up – leaving only those with the willingness and ability to pay to purchase the product. Be it the demand for tickets among England supporters for an Ashes cricket series or the demand for a rare antique, the market price acts a rationing device to equate demand with supply.
  • The popularity of auctions as a means of allocating resources is worth considering as a means of allocating resources and clearing a market.

Mixed and Command Economies and Prices

  • Most economies are mixed economies, comprising not only a market sector, but also a non-market sector, where the government (or state) uses planning to provide public goods and services such as police, roads and merit goods such as education, libraries and health.
  • In a command economy, planning directs resources to where the state thinks there is greatest need. Following the collapse of communism in the late 1980s and early 1990s, the market-based economy is now the dominant system in most countries – even though we are increasingly aware of many imperfections in the operation of the market.

Prices and incentives

  • Incentives matter! For competitive markets to work efficiently all ‘economic agents’ (i.e. consumers and producers) must respond to appropriate price signals in the market.
  • Market failure occurs when the signalling and incentive functions of the price mechanism fail to operate optimally leading to a loss of economic and social welfare. For example, the market may fail to take into account the external costs and benefits arising from production and consumption.  Consumer preferences for goods and services may be based on imperfect information on the costs and benefits of a particular decision to buy and consume a product.

Secondary markets

  • Secondary markets occur when buyers and sellers are prepared to use a second market to re-sell items that have already been purchased.
  • Perhaps the best example is the secondary market in tickets for concerts and sporting-events.

Do ticket touts provide a valuable service to a market? Or should they be banned by law?

Government intervention in the market mechanism

  • Often the incentives that consumers and producers have can be changed by government intervention in markets
  • For example a change in relative prices brought about by the introduction of government subsidies and taxation.

Government subsidies and taxation

Agents may not always respond to incentives in the manner in which textbook economics suggests.

The “law of unintended consequences” encapsulates the idea that government intervention can often be misguided of have unintended consequences! (See the final chapter on government failure)




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