1.2.7 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
    
    
• The price mechanism fulfils three functions in the relationship between buyers and sellers
  • Rationing: prices allocate (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
  • Signalling:  prices provide information to producers & consumers where resources are required (in markets where prices increase) & where they are not (in markets where prices fall)
  • 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 reallocation of resources to new markets 
    
    
• Adam Smith referred to the functions of the price mechanism as the 'mystery of the invisible hand'

• The price mechanism operates in all markets including local, national and global
  
  

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

• Due to a change in one of the conditions 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

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

• Due to a change in one of the conditions 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

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
  • 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

• 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 until recently been steady at $2/kg
• Due to a change in one of the conditions of demand (possibly an increase in 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 it for $3, receive it
  • 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