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