Functions of the Price Mechanism

The price mechanism plays three important functions in a market:
1/ Signalling function
• Prices perform a signalling function – they adjust to demonstrate where resources are required, and where they are not
• Prices rise and fall to reflect scarcities and surpluses
• If prices are rising because of high demand from consumers, this is a signal to suppliers to expand production to meet the higher demand
• If there is excess supply in the market the price mechanism will help to eliminate a surplus of a good by allowing the market price to fall.
Transmission of preferences
• Through their choices consumers send information to producers about the changing nature of needs and wants
• Higher prices act as an incentive to raise output because the supplier stands to make a better profit.
• When demand is weaker in a recession then supply contracts as producers cut back on output.
• One of the features of a market economy system is that decision-making is decentralised i.e. there is no single body responsible for deciding what is to be produced and in what quantities. This is a remarkable feature of an organic market system.
Rationing function
• Prices serve to ration scarce resources when demand in a market outstrips supply.
• When there is a shortage, the price is bid up – leaving only those with the willingness and ability to pay to purchase the product. Be it the demand for tickets among England supporters for an Ashes cricket series or the demand for a rare antique, the market price acts a rationing device to equate demand with supply.
• The popularity of auctions as a means of allocating resources is worth considering as a means of allocating resources and clearing a market.
Prices and incentives
• Incentives matter! For competitive markets to work efficiently all 'economic agents' (i.e. consumers and producers) must respond to appropriate price signals in the market.
• Market failure occurs when the signalling and incentive functions of the price mechanism fail to operate optimally leading to a loss of economic and social welfare. For example, the market may fail to take into account the external costs and benefitsarising from production and consumption. Consumer preferences for goods and services may be based on imperfect information on the costs and benefits of a particular decision to buy and consume a product.