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The price mechanism performs three main functions:

1. Rationing - when there is a shortage of a good, the price increases (it is "bid up"), leaving only those with the willingness/ability to pay to purchase the product. This causes supply and demand to reach an equilibrium.
2. Signalling - to demonstrate where resources are required, via a change in demand. For example, the price of goods which are scarce will increase. This increase in price should provide an incentive for producers to increase production of the good (i.e. a "signal" to producers).
3. Transmission of preferences - consumers are able to alert producers to changes in wants and needs, so that the market provides the right amount of the right goods.

Contents 1 Advantages of the price mechanism 2 Disadvantages of the price mechanism 3 Also See 4 Comments

Advantages of the price mechanism

• The great benefit of the price mechanism is the invisible hand of price described by Adam Smith. It is able to signal the cost of purchasing a good to the consumer and signal to the producer the revenue that they will receive from the good.
• The idea of consumer sovereignty - consumers have the power to determine what is bought and sold in the market.
• The freedoms of choice, property and enterprise can only be fulfilled in a system with operation of the price mechanism.
• Prices are as low as possible and resources go to the most efficient use.
• The system operates without regulation.

Disadvantages of the price mechanism

• Inequality of income and wealth
• Without government intervention, there will be under-provision of public and merit good
• Unemployment
• Inflation
• Wastage on advertising etc.

The alternative to using the price mechanism is a planned economy (such as those under communism).

Also See

Take a look at the other unit 1 A level economics revision notes:

• The Economic Problem (AQA, Edex, OCR, WJEC)
• Factors of production (AQA, OCR)
• Positive and normative economics (AQA)
• Specialisation and Trade (AQA, Edex, OCR, WJEC)
• Producer and consumer surplus (AQA, Edex, OCR, WJEC)
• Demand theory (AQA, Edex, OCR, WJEC)
• Supply theory (AQA, Edex, OCR, WJEC)
• Supply and Demand Equilibrium (AQA, Edex, OCR, WJEC)
• Elasticity of demand (AQA, Edex, OCR, WJEC)
• Elasticity of supply (AQA, Edex, OCR, WJEC)
• The Price Mechanism (AQA, Edex)
• Indirect Taxes and Subsidies (Edex)
• The labour market (Edex)
• Economies of scale (AQA)
• Allocative efficiency (OCR)

Comments