Functions of the Price Mechanism (DP IB Economics)

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

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

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

1. Resource allocation

• Signalling:  prices provide information to producers and consumers about where resources are wanted (markets with increasing prices) and where they are not (markets with decreasing prices)

• 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 the reallocation of resources to new markets 

2. Rationing

• Prices 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

The Price Mechanism at Work

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

1. 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

A diagram showing the increase in demand for honey in a local market, Long Island
 

Diagram Analysis 

• Due to a change in one of the non-price determinants 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

2. Price mechanism in a national market

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

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

Diagram Analysis

• Due to a change in one of the non-price determinants of supply (a decrease in costs of production), the supply of T-shirts in the UK has increased from S₁→S₂ and the price has fallen from P₁ to P₂

  • The lower price increases the number of consumers who can access this product. It is rationed more widely as there is an excess in supply 

  • The lower price incentivises consumers to purchase more T-shirts and this is evident from the increase in demand from Q₁ to Q₂

  • The shift in supply signals to other producers that there is excess supply and they should consider leaving the market

3. 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 (these are products in competitive supply)

  • Many countries export excess crops into the world market

  • Producers use world prices to guide their production decisions
    
    

A diagram showing the price mechanism at work in two related global markets, corn and potatoes
 

 Diagram Analysis

• 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 been steady at $2/kg

• Due to a change in one of the non-price determinants of demand (possibly an increase in the 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 potatoes for $3, receive them

  • 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

  • If they do this, the supply of corn will shift to the left