The Market (Price) Mechanism (AQA A Level Economics)

• The price mechanism is the interaction of demand and supply in a market economy that allocates scarce resources amongst competing needs and wants
• Adam Smith referred to the functions of the price mechanism as the 'invisible hand of the market'
  
• The price mechanism fulfils three functions in the relationship between buyers and sellers which include rationing, incentivising and signalling
• When any of these functions breaks down, market failure can occur
  

Functions of the Price Mechanism

Function	Explanation
Rationing	When resources become scarce, the price will rise. 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 E.g The price of plane tickets might rise as seats are sold, because spaces are running out. This is a disincentive to some consumers to purchase the tickets, which rations the tickets
Incentive	The incentive function encourages producers to increase or decrease output to increase profits When prices for a good/service rise, it incentivises producers to reallocate resources from a less profitable market in order to maximise their profits Falling prices incentivise reallocation of resources to new markets
Signalling	A change in price provides a signal to consumers and producers about where resources are wanted (markets with increasing prices) and where they are not (markets with decreasing prices) This allows consumers and producers to make informed decisions High prices signals to a producer to produce more of that good/service and would signal to other producers to enter the market A falling price signals to consumers to purchase more or a product

• 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

Diagram analysis

• 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

Diagram analysis

• 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

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 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

• The price mechanism allows for efficient allocation of resources in a free market
  • There is no need for government intervention or planning, as price signals incentive to allocate more or less resources

Evaluating the Price Mechanism

Advantages

Disadvantages

There is an efficient allocation of resources under price mechanism as markets adapt to changes quickly Resources are allocated to their most valued use for production and consumption   Consumers have the freedom to choose goods and services based on tastes, preferences, and income This gives consumers more power to influence what firms produce As a result, producers then allocate resources towards needs and wants of consumers Giving them an incentive to be innovative and develop new areas of business activity  This allows them to maximise their profits

It is an impersonal method of allocating resources, as it does not take into account consumer utility or decision making   It may create inequality as only those with higher incomes  have buying power Asymmetric information and monopoly power can lead to consumers being exploited by firms Under provision of public goods causes market failure The use of the price mechanism in some markets could be undesirable or distort incentives  E.g. Using price mechanism for markets for life saving treatments such as blood or organ donations would incentivise high prices and create inequalities in access