The Price Mechanism

The price mechanism is the means by which decisions of consumers and businesses interact to determine the allocation of resources.
It does not necessary lead to a equitable distribution of resources, and can lead to market failure.

Functions of the price mechanism

Signalling

The price adjusts to demonstrate where resources are required or not required.

An increase in the price of coffee may make producers switch to make more coffee, and may cause consumers to consume less coffee / use a substitute.

Rationing

Higher prices man that only those willing and able to pay are included in the demand. This means when there is a shortage, raising the price will reduce demand.

Allocation

Prices allocate scarce resources among competing uses.

Incentives

When the price of a product rises, quantity supplied increases as businesses respond.

Examples

A taxi firm raises fares at its busiest times by as much as 5x the normal fare. Taxi drivers and customers are notified of the changes by mobile phone. What will result from this policy?

• A - It will be less likely that there is a market equilibrium
• B - Potential customers will have less perfect information?
• C - The market surplus will become a shortage
• D - The supply of taxi rides will become more price elastic.

D - Taxi drivers are more willing to supply rides during higher price times, so the supply will increase in response to price.