Price mechanism – an economic model that helps to explain the allocation of resources between different possible uses.
The invisible hand guides resources towards goods/services that consumers want. The invisible hand is an unobservable market force that helps the demand and supply of goods in a free market reach equilibrium automatically. The price mechanism was called ‘the invisible hand of the market’ by Adam Smith who was a Scottish economist who used it to describe the unintended social benefits of individual self-interested actions. It suggests that the market works to benefit society when individuals work for their own purpose more than when it is intended to help society.
WHAT DOES THE PRICE MECHANISM DO?
- Determines the market price
- Solves the problem of allocating resources
- Moves resources to where there is a shortage and the prices are higher
- Resources move away from where there is a surplus and prices are lower
HOW DOES THE PRICE MECHANISM WORK TO ALLOCATE RESOURCES?
- Market signalling
- Giving incentives
- Rationing
- Allocation of resources
Signalling Allocation Rationing Incentives
1) Market signalling:
- Prices act as market signals; a high price attracts new firms to the market and guides resources to production as it is profitable.
- g. if a product is in high demand, it is a signal to suppliers to expand production and that it is a profitable venture and they should produce it.
- However high prices can also deter customers.
- If there is excess supply (surplus) in the market, the price mechanism will eliminate it by allowing the market price to fall.
- Prices rise and fall to reflect scarcities and surpluses.
2) Gives incentives:
- Profitability motivates firms
- Good value products attracts customers
3) Rationing:
- High prices deter customer so by raising prices you are effectively rationing as not everyone can afford that prices.
- When resources are scarce, prices rise and demand falls (rationing)
HOW DO FIRMS RESPOND TO A CHANGE IN DEMAND?
Rising prices indicate rising demand à so firms increase output therefore increasing profits
Falling prices indicate falling demand à so firms should cut prices and reduce output or create new product
STRENGTHS OF THE PRICE MECHANISM
- Works automatically, following decisions taken by many economic agents.
- Directs resources to the best possible uses.
A niche market is generally better at allocating resources to where consumers want, since niche markets are closer to the consumer. It could be argued that it is more profitable to be in a niche market, since the consumers are targeted directly, rather than generally. This makes the allocation of resources more efficient.
Consumer sovereignty – the power of consumers to determine what is produced as it their needs and wants control the output of suppliers.
Potential market growth
Market size – the total sales volume of a given market i.e. in 2016 the UK grocery market was £179.1 billion. This informs supermarkets of potential future sales.
Market growth implies an increase in demand for a product. This may be due to rising incomes and population, better substitutes or the product becoming cheaper (through businesses reducing costs).
Market change
- Markets are not usually static (some grow and some shrink)
- Technology can be a factor: smart phones.
- Consumer tastes is another factor.
Market share – the percentage of a market’s total sales that a particular business has.