In a free market, the price of goods and services are determined by the forces of demand and supply. Which means the interactions of buyers and sellers determine the price of goods and services in a market. Determining and changes in the price through price mechanism can allocate resources. Resources move towards where they are in the shortest supply in comparison to demand, and away from where they are least demanded.
Price mechanism – The rationing function
Rationing means distributing the resource that is in shortage among those who are in need for it, even though each person may not get as much as he wants. In case of price mechanism, when a particular resource is in shortage, the excess demand over supply will drive up the prices, which will decrease the quantity demanded of that resource and the system has a rationing effect, as well as a conserving effect.
Price Mechanism – The Signalling function
Price changes send contrasting messages to consumers and producers about whether to enter or leave a market. Rising prices signals to consumers to reduce demand or withdraw from a market completely, and they give a signal to the existing producers to increase production or to potential producers to enter a market. On the other hand, falling prices signals to consumers to enter a market while sending a negative signal to producers to leave a market. For example, a rise in the market price of smartphones sends a signal to potential manufacturers to enter this market, and perhaps leave another one. Similarly, the provision of ‘free’ healthcare may signal to ‘consumers’ that they can pay a visit to their doctor for any minor ailment, while potential private healthcare providers will be discouraged from entering the market. In terms of the labour market, a rise in the wage rate provides a signal to the unemployed to join the labour market.
Price Mechanism – The Incentive function
An incentive is something that motivates a producer or consumer to follow a course of action or to change behaviour. Higher prices provide an incentive to existing producers to supply more because they provide the possibility or more revenue and increased profits. The incentive function of a price rise is associated with an extension of supply along the existing supply curve.