Price Mechanism (Edexcel A Level Economics A)

Revision Note

Steve Vorster

Written by: Steve Vorster

Reviewed by: Jenna Quinn

Functions of The Price Mechanism

  • The price mechanism is the interaction of demand and supply in a free market

    • This interaction determines prices which are the means by which scarce resources are allocated between competing wants/needs

  • The price mechanism fulfils three functions in the relationship between buyers and sellers

    • Rationing: prices allocate (ration) scarce resources. When resources become scarcer the price will rise further. Only those who can afford to pay for them will receive them. If there is a surplus then prices fall and more consumers can afford them

    • Signalling:  prices provide information to producers and consumers where resources are required (in markets where prices increase) and where they are not (in markets where prices fall)

    • Incentive: when prices for a good/service rise, it incentivises producers to reallocate resources from a less profitable market to this market in order to maximise their profits. Falling prices incentivise reallocation of resources to new markets 

  • Adam Smith referred to the functions of the price mechanism as the 'mystery of the invisible hand'

Price Mechanism at Work in Different Markets

  • The price mechanism operates in all markets including local, national and global

Price mechanism in a local market

  • Long Island, USA has a rich history of agriculture and many producers set up farm shops selling directly to the public. In recent years, honey consumption has increased

1-2-7-local-market_edexcel-al-economics
A diagram showing the increase in demand for honey in a local market, Long Island
  • Due to a change in one of the conditions of demand (most likely change in tastes), the demand for honey in the local market has increased from D1→D2 and the price has increased from $15 to $18

    • The higher price serves to ration a valuable product. Those consumers who can afford to purchase it at $18, receive it

    • The higher price incentivises producers to allocate more factors of production to producing honey and this is evident from the extension in supply from Q1 to Q2

    • The shift in demand signals to other producers that demand for honey is strong and they should consider entering the market

Examiner Tips and Tricks

It can get confusing explaining some of the differences between the three functions. Thinking about it in the following way helps to simplify the process. If there is shift in demand/supply the market is sending a signal to consumers and producers. If there is a movement along one of the curves, this is as a result of the incentive function.

Price mechanism in a national market

  • The T-Shirt market in the UK is highly competitive. In 2018 the price of cotton fell

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A diagram showing an increase in the supply of T-shirts in the UK market

Price mechanism in a global market

  • Cash crops such as wheat, oats, barley, soy, corn, sunflowers etc. can be grown using the same factors of production

    • Many countries export excess crops into the world market

    • Producers use world prices to guide their production decisions

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A diagram showing the price mechanism at work in two related global markets, corn and potatoes
  • Farmers in France have been producing corn for many years and the market price is $2/kg. The price of potatoes in global markets has until recently been steady at $2/kg

  • Due to a change in one of the conditions of demand (possibly an increase in global population), the demand for potatoes has increased from D1→D2 and the price has increased from $2/kg to $3/kg

    • The higher price serves to ration the potatoes. Those consumers who can afford to purchase it for $3, receive it

    • The higher price incentivises producers to allocate more factors of production to producing potatoes and this is evident from the extension in supply from Q1 to Q2

    • The shift in global demand signals to producers in France that demand for potatoes is strong and they should consider switching some of their production from corn to potatoes

Examiner Tips and Tricks

Whenever you are faced with questions on the functions of the price mechanism, remember that all three functions are built on the principle of self-interest. This will help you to explain each function.

For example, lower prices incentivise consumers to purchase more of the product with the same income. Conversely, the incentive for producers is the opposite, encouraging them to reallocate their factors of production to producing more profitable products.

Each party acts in their self interest

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Steve Vorster

Author: Steve Vorster

Expertise: Economics & Business Subject Lead

Steve has taught A Level, GCSE, IGCSE Business and Economics - as well as IBDP Economics and Business Management. He is an IBDP Examiner and IGCSE textbook author. His students regularly achieve 90-100% in their final exams. Steve has been the Assistant Head of Sixth Form for a school in Devon, and Head of Economics at the world's largest International school in Singapore. He loves to create resources which speed up student learning and are easily accessible by all.

Jenna Quinn

Author: Jenna Quinn

Expertise: Head of New Subjects

Jenna studied at Cardiff University before training to become a science teacher at the University of Bath specialising in Biology (although she loves teaching all three sciences at GCSE level!). Teaching is her passion, and with 10 years experience teaching across a wide range of specifications – from GCSE and A Level Biology in the UK to IGCSE and IB Biology internationally – she knows what is required to pass those Biology exams.