Price Mechanism

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The Price Mechanism

The price of a good/service is the value it's exchanged at. The price mechanism involves using the invisible hand to achieve an efficient allocation of resources.

The price mechanism

The price mechanism shows how demand and supply interact.
A change in the price of a good will change the quantity demanded.
The price mechanism is free from bias because it is not governed by one human, but lots of different agents interacting.

Functions of the price mechanism

Incentive function: rising prices encourage firms to expand their level of output because of higher profits.
Signalling function: if the price of a good changes, this signals to the consumer or producer that they should change their level of consumption or production.
Rationing function: resources are scarce. The price of a good rations that good. This limits supply to those who are willing and able to pay for it.

The price mechanism locally & globally

Local markets: In a local marketplace for fruit, if one market stall sells apples for £20 and sells out of 1,000 apples. Then this is a signal for that firm to increase production and sell more apples. It also signals to competitors that they should start selling apples.
National markets: If Amazon lists a book at £10, but nobody buys it, then there is a signal that nobody demands that book at £10. Either people don't want the good or they are buying it elsewhere at a lower price. There is an incentive to reduce the quantity produced or to reduce the sale price.
Global markets: If the USA can produce steel for £100/ton and sells it for £1,000/ton, this is a signal to nations like China and India that they can make profits by producing steel. They have an incentive to produce steel and enter the market.

Advantages and Disadvantages of the Price Mechanism

There are costs and benefits associated with using the price mechanism.

Advantages of price mechanism

It is allocatively efficient.
There is no time cost because no-one needs to be paid to monitor it.
The process is efficient because prices are as low as possible.
Consumers have control over what producers make.

Disadvantages of price mechanism

Some goods objectively shouldn't be produced through the price mechanism.
- E.g being able to buy an organ through the price mechanism isn't necessarily fair.
There will be missing markets for some goods.
- E.g street lighting
There will be a huge disparity in wages for low skill and high skill workers, increasing inequality.
The price mechanism usually has no moral overlay or beliefs before a government intervenes.

Unintended consequences of price mechanism

Market failure can arise through unintended consequences.
- E.g people who donate bone marrow might do it for reasons outside of the price mechanism.
- By offering payment, it may discourage them from donating, which could lower the total amount of bone marrow donators.
Michael Sandel has done work on social vs market norms. Sometimes social norms rule our lives.