Functions of the Price Mechanism (HL IB Economics)
Revision Note
The Price Mechanism
The price mechanism is the interaction of demand and supply in a free market
This interaction determines prices which are the means by which scarce resources are allocated between competing wants/needs
Adam Smith referred to the functions of the price mechanism as the 'mystery of the invisible hand'
The price mechanism fulfils two functions in the relationship between buyers and sellers
1. Resource allocation
Signalling: prices provide information to producers and consumers about where resources are wanted (markets with increasing prices) and where they are not (markets with decreasing prices)
Incentive: when prices for a good/service rise, it incentivises producers to reallocate resources from a less profitable market to this market in order to maximise their profits. Falling prices incentivise the reallocation of resources to new markets
2. Rationing
Prices ration scarce resources
When resources become scarcer the price will rise further. Only those who can afford to pay for them will receive them
If there is a surplus then prices fall and more consumers can afford them
The Price Mechanism at Work
The price mechanism operates in all markets including local, national and global
1. Price mechanism in a local market
Long Island, USA has a rich history of agriculture and many producers set up farm shops selling directly to the public. In recent years, honey consumption has increased
A diagram showing the increase in demand for honey in a local market, Long Island
Diagram Analysis
Due to a change in one of the non-price determinants of demand (most likely change in tastes), the demand for honey in the local market has increased from D1→D2 and the price has increased from $15 to $18
The higher price serves to ration a valuable product. Those consumers who can afford to purchase it at $18, receive it
The higher price incentivises producers to allocate more factors of production to producing honey and this is evident from the extension in supply from Q1 to Q2
The shift in demand signals to other producers that demand for honey is strong and they should consider entering the market
Examiner Tip
It can get confusing to explain some of the differences between the two functions. Thinking about it in the following way helps to simplify the process. If there is a shift in demand/supply the market is sending a signal to consumers and producers. If there is a movement along one of the curves, this is as a result of the incentive function.
2. Price mechanism in a national market
The T-Shirt market in the UK is highly competitive. In 2018 the price of cotton fell
A diagram showing an increase in the supply of T-shirts in the UK market
Diagram Analysis
Due to a change in one of the non-price determinants of supply (a decrease in costs of production), the supply of T-shirts in the UK has increased from S1→S2 and the price has fallen from P1 to P2
The lower price increases the number of consumers who can access this product. It is rationed more widely as there is an excess in supply
The lower price incentivises consumers to purchase more T-shirts and this is evident from the increase in demand from Q1 to Q2
The shift in supply signals to other producers that there is excess supply and they should consider leaving the market
3. Price mechanism in a global market
Cash crops such as wheat, oats, barley, soy, corn, sunflowers etc. can be grown using the same factors of production (these are products in competitive supply)
Many countries export excess crops into the world market
Producers use world prices to guide their production decisions
A diagram showing the price mechanism at work in two related global markets, corn and potatoes
Diagram Analysis
Farmers in France have been producing corn for many years and the market price is $2/kg
The price of potatoes in global markets has been steady at $2/kg
Due to a change in one of the non-price determinants of demand (possibly an increase in the global population), the demand for potatoes has increased from D1→D2 and the price has increased from $2/kg to $3/kg
The higher price serves to ration the potatoes. Those consumers who can afford to purchase potatoes for $3, receive them
The higher price incentivises producers to allocate more factors of production to producing potatoes and this is evident from the extension in supply from Q1 to Q2
The shift in global demand signals to producers in France that demand for potatoes is strong and they should consider switching some of their production from corn to potatoes
If they do this, the supply of corn will shift to the left
Examiner Tip
Whenever you are faced with questions on the functions of the price mechanism, remember that the functions are built on the principle of self-interest. This will help you to explain each function.
For example, lower prices incentivises consumers to purchase more of the product with the same income. Conversely, the incentive for producers is the opposite encouraging them to reallocate their factors of production to producing more profitable products.
Each party acts in their own self interest
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