Data Bases • Custom Term Papers • Free Term Papers • Free Research Papers • Free Essays • Free Book Reports • Plagiarism? Links • Top 100 Term Paper Sites • Top 25 Essay Sites • Top 50 Essay Sites • Search 97,000 Papers @ DirectEssays.com • Search 101,000 Papers @ ExampleEssays.com • Search 90,000 Papers @ MegaEssays.com Free Essays • Term Paper Sites • Chuck III's Free Essays • Free College Essays • TermPaperSites.com • My Term Papers • Get Free Essays • Essay World • Planet Papers	Search Lots of Essays Back to Subjects - Economics Price Mechanism Price Mechanism Economics – The Price Mechanism The Price Mechanism is perhaps the most basic feature of the market economy for allocating resources to various uses. It is the system in a market economy whereby the decisions of producers determine the supply of commodity and the decisions of buyers determine the demand. The interaction between the consumers’ demand for a good and the supply of that good by a producer determine the price. To put more simply; prices are determined by shortages and surpluses. Normally a shortage of a product causes the price to rise, whereas a surplus causes the price to fall. The price will determine how much of a product a producer decides to supply. If the product price is high then profit is greater and more will be supplied due to producer profit motive. If consumers decide that they want more of a good (or if producers decide to cut back supply), then demand will exceed supply. The resulting shortage causes the price to rise. The result is that consumers will be discouraged to buy as much whereas producers will be encouraged to supply more. The price of a good will continue to rise until the shortage has been eliminated. The opposite is true if consumers decide that they want less of a good causing the price to fall until the surplus is eliminated. As this process is continued we can see that there is only one price at which there is neither upward nor downward pressure on price. This is termed the equilibrium price and occurs when demand equals supply. The price mechanism can only function fully within a free market economy thereby ensuring the allocation of all resources without the need for government intervention. A free market economy exists where government intervention is minimal, land and capital are privately owned, consumers are free to decide what they want to buy and producers are free to produce any good. Also workers are free to choose where, for whom and when they work. Consumers are very powerful, being free to accept or reject whatever is produced in the market place. This ’sovereignty’ ultimately determines production. The price mechanism balances the production and consumption of goods whilst assuming the following: firms seek to maximise profits; consumers seek value for money from their purchases; workers seek to maximise their wages relative to the human cost of working in a particular job. Adam Smith referred to this pursuit of self-interest as the “Invisible Hand”. Advantages of the Free Market Economy The main influence is that it operates automatically without the need for government intervention to either supply, demand or price levels. Also competition between firms keeps prices down and acts as an incentive to firms to become more efficient. The more firms who compete, means the more responsive they will be to consumer wishes. Situations where the competition level is high prevents any one person or company becoming overly influential. Disadvantages of the Free Market Economy Large firms may dominate an industry and this monopoly enables them to charge high prices and make large profits irrespective of consumer wishes. They may therefore lack incentive to improve efficiencies. By advertising, firm’s can mislead or create false impressions when persuading consumers who are susceptible to advertisements for products that are new to them and of which they have little knowledge. Another problem is that the free market economy may lead to macroeconomic instability, there may be periods of recession with high employment and falling output, and other periods of rising prices. Similarly, the overriding self interest motive may lead companies to act without any social or moral responsibility e.g. charitable donations. To analyse the effectiveness of the price mechanism within the free market it should be compared to alternative market economies. The command economy works on the principle that instead of having to rely on the decisions of millions of individuals, the government actively manages the economy in the interests of society. It directs the nation’s resources in accordance with specific national goals. In practice, maintaining one specific style has proved virtually impossible due to the governments’ political and social agenda. Therefore a mixed market economy, a combination of the two has evolved. As stated, a market economy where there is some government intervention although the degree of intervention is important in ascertaining the effectiveness of the price mechanism. The main components of the mixed economy are summarised as:  A free enterprise sector – decisions taken through the workings of the market  Government regulation – through budgets etc  Public ownership of some industries Difficulties facing the price mechanism An increase in the power of the state has become a central fact of modern society. Important decisions about production and distribution have been made through the political process rather than through the market place. The intervention of the Government can take a number of forms.  Fixing prices above or below the free market equilibrium  Taxing the production or sale of carious goods  Subsidising the production or sale of various goods The government could nationalise various industries or run them directly from government department (e.g. defence and health). Various laws have been passed to regulate the behaviour of firms. For example, public transport or armaments production. Licences or official permission have to be obtained to produce certain goods, a regulatory body supervises the activities of various firms and prevent any that it feels to be against the public interest (e.g. the production of drugs). In addition to government intervention in the market place further dislocation of the price mechanism can occur, for example European laws passed by the European Union as they strive for conformity amongst member nations. Price control is a clear example where government intervention disrupts the price mechanism. Prices can be effected in a number of ways. A government subsidy will artificially reduce the price of a good and boost demand, an example being certain foodstuffs. Conversely, a government tax or tariff in a good in this way will increase its price to the consumer and decrease demand. This illustrates how government can use the efficiency of the price mechanism to change supply and demand. The reason for their interaction can be based on economic, social or political factors. For instance, tobacco products are taxed very heavily thus artificially raising the price of the product. This reduces demand for cigarettes despite their inelastic nature, thereby benefiting the general health of the population whilst raising substantial revenues for other social programmes. There are instances where manipulating the price mechanism can bring undesirable results. During the late 1980’s and early 1990’s subsidies were given to farmers in Europe to encourage production of certain foodstuffs where supply was dwindling due to low prices. A ‘price floor’ was established where a farmer earned a minimum sum for his goods. This encouraged additional production of particular foodstuffs as farmers acted as if in a free market economy. The outcome was that huge surpluses of food such as butter and beef accumulated, which had to be stored by the authorities. Eventually much was just discarded. Huge sums of taxpayers money had to be spent distorting the free market, resources had been wasted and the farmers had to revert to producing economic products. A price ceiling will similarly distort the economy. Many producers will discontinue production due to its uneconomic nature and provide goods into the free market or unofficial market (black market) where the price mechanism is able to function. As these goods are in short supply the black market price will be much higher. This was illustrated in WW2 when food was in short supply and had to be rationed. Those with sufficient money would still obtain goods, on the black market. As the free market is based on the principle that individuals should be free to do what they want, it is not surprising to discover that the motive for all economic activity is Adam Smiths ‘invisible hand’ namely self interest. Each person in the economy attempts to do what is best for themselves. Firms will act in ways in which, they believe will lead to maximum profits (or minimum losses). Owners of land and capital will employ these assets so as to obtain the highest possible rewards. Workers will tend to move to those occupations and locations, which offer the highest wages. Consumers will spend their incomes on those things, which yield the maximum satisfaction at the most economic cost. Advocates of the price mechanism namely Smith believed that the individual pursuit of self-interest would lead to the maximum public good. In ‘The Wealth of Nations’ he argued that ‘By pursuing their own interests the individual frequently promotes that of society more effectively than they really intend to promote it.’ Milton Freidman’s assertions appear to agree in terms of the price mechanism in a free market economy and pursuit of self-interests. I have however highlighted shortcomings in this system in real life where it would appear that some form of mixed economy is likely to be most successful. The degree of intervention by the government or other authority should be one of a limited and cautious nature to avoid distorting the operation of the price mechanism in essentially a free market economy. Bibliography: BIBLIOGRAPHY Economics – third edition - John Sloman – Prentice Hall 1997 Economics – A students Guide – third edition – J Beardshaw with contributions by Andy Ross – Pitman Publishing 1992 Word Count: 1567
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