Functions of the Price Mechanism
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The price mechanism has four main functions: 1) Allocation of scarce resources through prices that signal relative scarcity. 2) Rationing of scarce resources when demand exceeds supply through higher prices deterring some consumers. 3) Signalling changes in market conditions through price adjustments that inform producers and consumers. 4) Incentivizing consumers and suppliers by changing incentives in response to price changes. In an economy like the UK, prices resolve issues of trade-offs and opportunity costs. The rationing and signalling functions are then discussed in more detail with examples.
Functions of the Price Mechanism
- 2. Main Functions of the Price Mechanism 1. Allocate – allocating scarce resources among competing uses 2. Rationing – prices serve to ration scarce resources when market demand outstrips supply 3. Signalling – prices adjust to demonstrate where resources are required, and where they are not 4. Incentives – e.g. when the price of a product rises, quantity supplied increases as businesses respond! Prices send important signals Prices change incentives for consumers and suppliers In an economy like the UK, many decisions on how to resolve the issues of opportunity cost and trade-offs are resolved by prices.
- 3. The Rationing Function The rationing function - when there is a shortage of a product, price will rise and deter some consumers from buying the product Higher food prices Rising cost of renting Online auctions Tickets for major event D1 P1 Price Quantity S1S2 P2 In recent years the rise in food prices plus declining real incomes has highlighted the rationing function of the price mechanism
- 4. The Signalling Function The signalling function - changes in price provides information to both producers and consumers about changes in market conditions Coffee farmers Shale oil and gas Share prices send signals Interest rates on loans “Cotton farmers hit hard as prices drop to lowest since 2009” (December 2014) Plentiful global supplies of cotton thanks to favourable weather have caused cotton prices to fall to a 5 year low. China’s farmers benefited from a $5bn scheme which ran from 2011-14 where the government purchased cotton at a minimum price, building up a huge stockpile — China’s reserves have risen six-fold since 2010 and it holds 60% of the world’s cotton inventories. The slump in prices is being badly felt by growers in the southern African country Zambia whose cotton industry employs a fifth of the population. Consider the price signals in this example
- 5. Real World: Explaining Changes in UK Footwear Prices 80 85 90 95 100 105 110 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 ConsumerpriceindexforfootwearproductsinUK Global competition from lower cost countries Intense retail competition on the high street and online Falling input costs have increased market supply Strong exchange rate – which makes imports of shoes cheaper