A) Functions of the price mechanism

Wants are unlimited but resources are scarce, so there needs to be a way of allocating those resources between competing uses. In a free market, changes in prices help to perform this role.

Rationing

Prices can ration scarce goods and services between consumers. For example, if there is excess demand, there will be upward pressure on price.

As price rises, fewer consumers will be willing and able to buy the good or service. This contraction in demand helps to reduce the excess demand and move the market towards equilibrium.

Signalling

Changes in prices send signals to consumers and producers about conditions within a market.

A rising price can signal to consumers that a good has become more scarce, encouraging them to reduce demand. It can also signal to producers that there may be an opportunity to increase output or enter the market.

Falling prices can send the opposite signal, encouraging consumers to increase demand while giving producers less incentive to supply the product.

Incentives

Prices also create incentives. If the price of a good rises, the potential profit from selling each unit may increase.

A profit-maximising firm therefore has an incentive to increase supply. This extension in supply can help reduce excess demand and move the market closer to equilibrium.

B) The price mechanism in different markets

The functions of the price mechanism can operate in local, national and global markets. In each case, changes in supply and demand can affect prices and therefore influence the decisions made by consumers and producers.

What the full guide adds

For this topic, the full AS guide also covers:

• A fuller application of the price mechanism to local, national and global markets.
• A detailed UK housing-market example, showing how scarcity and differences in demand can affect house prices in different locations.
• More explanation of how higher prices ration excess demand when resources are scarce.
• How government intervention can distort price signals and prevent the price mechanism from operating freely.