Price Determination » The Price Mechanism

Who decides what gets made?

Think about how a large city gets fed. Nobody in charge plans how much bread, rice or fruit each street needs. Yet shops are usually stocked each morning. How?

In a market, the answer is prices. Buyers and sellers act in their own interests, and prices change as they do. Those changing prices steer resources towards the things people want. Remember from What, How and For Whom to Produce that every economy must answer three questions. This lesson shows how markets answer them without anyone giving orders.

Key terms:

• Price mechanism: the way the interaction of demand and supply decides prices, and so decides how resources are allocated.
• Signalling: prices tell producers and consumers what is happening in the market.
• Incentive: a reason to act. Price changes give buyers and sellers a reason to change what they do.
• Rationing: sharing out limited goods. Price decides who gets them.

The three jobs of price

The price mechanism works because price does three jobs at once.

What to produce?

Consumers vote with their money. If more people want a good, demand increases and its price tends to rise. That price rise is a signal to producers.

It is also an incentive. A higher price means a higher profit on each item sold. Profit attracts producers into that market, so more of the good is made. Resources move towards the goods consumers want most.

The reverse also happens. If a good goes out of fashion, demand falls, the price falls and profits shrink. Some firms switch to making something else, and resources move away.

How to produce?

Firms in a market want to keep costs low so that profit is as high as possible. So they choose the cheapest combination of factors of production that can make the good.

The prices of the factors guide this choice. If wages rise, workers become expensive, so a firm may use more machines. If machines become cheaper, the firm may switch to them. If labour is cheap, the firm may use more workers.

No one tells the firm what to do. Its own search for lower costs and higher profit does the job.

For whom to produce?

In a market, goods go to those who are willing and able to pay the price. This is where rationing comes in. Remember effective demand: wanting something is not enough, you also need the money to buy it.

If a good is scarce, its price rises. The higher price puts off some buyers, and the limited supply goes to those who will pay. People with more income can buy more. People with less income can buy less.

A story: a product becomes popular

Here is a made-up example. In the country of Zentria, a firm makes foldable electric scooters. Social media makes them fashionable.

1. Demand increases. More people are willing and able to buy scooters at every price. On a diagram, the demand curve D shifts to the right to D1.
2. The price rises. Shops sell out and begin to charge more. The price goes up from P1 to P2.
3. Signal. The higher price tells producers that consumers want more scooters.
4. Incentive. Profit on each scooter rises. The firm makes more, and new firms enter the market.
5. Resources move. Workers, factories and metal are drawn towards scooters and away from less profitable goods. This answers what to produce.
6. Cheapest methods. Firms use the cheapest mix of factors, perhaps more robots on the assembly line if wages are high. This answers how to produce.
7. Rationing. Those willing and able to pay the higher price get the scooters. This answers for whom to produce.

Nobody planned this. The price mechanism did it.

Drawing it

In the exam, draw a demand and supply diagram. Put Price on the vertical axis and Quantity on the horizontal axis. Draw a downward sloping demand curve labelled D and an upward sloping supply curve labelled S. Then draw a second demand curve to the right of the first and label it D1. Mark the old price P1 and the new, higher price P2 on the vertical axis, and the quantities Q1 and Q2 on the horizontal axis. A higher price and a larger quantity show that the market has responded to the extra demand.

Exam-style question

In the country of Orvale, a new fruit drink becomes very fashionable. Demand rises sharply and the price of the drink goes up. Many new firms start making it.

(a) Define the price mechanism. [2 marks]

(b) Explain why the higher price encourages firms to produce more of the drink. [3 marks]

(c) Analyse how the price mechanism helps to decide for whom the drink is produced. [4 marks]