The role of the price mechanism

The role of the price mechanism

The price mechanism moves the market into equilibrium, so that the scarce resources are reallocated.

Opportunity cost: is the next best alternative forgone. When a choice is made, there is an opportunity cost.

Rationing function: Prices serve to ration scarce resources when demand in a market outstrips supply.

Signalling function: prices rise and fall to reflect surpluses and scarcities, which shows where resources are required.

If prices of bikes 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.

An increase in market supply causes a fall in the relative prices of laptops and prompts an expansion along the market demand curve.

When there is a shortage, the price is bid up – leaving only those with the willingness and ability to pay to purchase the product. The market price acts a rationing device to equate demand with supply.

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.

Market efficiency

Consumer surplus: the extra satisfaction a consumer gains from paying a price less than they were prepared to pay.

Producer surplus: the excess of actual earnings that a producer makes from a given quantity of output, over and above the amount the producer would be prepared to accept for that output.

When a market is allocatively efficient, the social (community) surplus is maximised, this is made up of the consumer and producer surplus. This means that the marginal social benefit = the marginal social cost.

Allocative efficiency happens when competitive market is in equilibrium, where resources are allocated in the most efficient way from society’s point of view.