Price mechanism

A) Functions of the price mechanism to allocate resources:

As wants are unlimited, but resources are scarce and therefore there needs to be a way in which the market can allocate these resources. This is called the invisible hand. The functions of the price mechanism help to allocate these resources in order to sure that the market is operating efficiently as possible (at a point of equilibrium). This ensures that there is not an excess of demand or supply in the market. The three main functions of the price mechanism include:

Rationing – Any excess demand/supply in the market will be solved through the price mechanism of rationing. For example, if there is an excess of demand in the market there will be upwards pressure on prices. Therefore, as suppliers increase their prices the excess demand will be rationed as fewer consumers will be willing and able to buy the good/service at that more expensive price. As a result, there will be a contraction in demand resulting in the market operating at equilibrium. If there is an excess of supply in the market then there will be downwards pressure on price.

Signalling – The rising prices caused by the rationing function during excess demand send signals to consumers to reduce their demand or stop buying the good/service completely. On the other hand, decreasing prices in the market caused by the market getting rid of excess supply sends a signal to consumers to increase their demand for the good/service. In addition to this, if prices are falling then this sends a signal to producers that they should leave the market as there is less money to be made. However, if prices are increasing then this price movements acts as a signal to producers that they should either enter the market or increase their production of goods/services into the market. Overall, this helps to prevent excess demand/supply moving the market towards equilibrium.

Incentives –Higher prices in the market caused by the rationing of excess demand incentivises producers to increase the supply of goods/services into the market. This is because the profit made on each good/service sold increases. As a result of this, any rational producer (one that profit maximises) will increase their supply. This extension of supply helps to reduce excess demand and therefore moves the market closer to equilibrium.


B) The price mechanism in the context of different types of markets, including local, national and global markets:

The functions of the price mechanism can be seen in any free market whether local, national or global. For example, in the UK there is a continuing issue with the scarcity of houses. This has resulted in increases in the prices of houses in the UK in order to try and ration this demand. Furthermore house prices are dependent on the location of the house.

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