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The workings and effectiveness of the price mechanism

In this essay I am going to analyse the workings and effectiveness of the price mechanism as a means of allocating and reallocating scarce resources. I am going to do this by comparing the free market economy with its alternatives and by looking at how government intervention allows the price mechanism to carry on working. I am also going to look at the role that we, as consumers, play in the workings of the price mechanism.

Definition & Workings of the Price Mechanism

The Price Mechanism: The system in a market economy whereby changes in price in response to changes in demand and supply have the effect of making demand equal to supply.

The price mechanism works as follows, prices respond to shortages and surpluses. Shortages cause prices to rise, Surpluses cause prises to fall. The price of a product will either encourage producers to supply more or less, the higher the price the higher their profit and the more they are going to want to supply.

For example should consumers decide that they want more of a good (of if producers decide to cut back supply), demand will exceed supply. The resulting shortage will cause the price of the good to rise. This will act as an incentive to producers to supply more and will discourage consumers from buying so much. Price will continue to rise until the shortage has thereby been eliminated.

The exact opposite is true if consumers decide that they want less of a good. Price will continue falling until the surplus had been eliminated.

The same analysis can be applied to factor markets. If the demand for a particular type of labour exceeded its supply, the resulting shortage would drive up the wage rate, thus reducing firm's demand for that type of labour and encouraging more workers to take up that type of job. Wages would continue rising until demand equalled supply or until the shortage was eliminated.

The result of this is that, in theory, the allocation of all resources happens without the need of government intervention and only through the price mechanism.

Free Market Economy

The price mechanism can only function within a free market economy. A free market economy is one where government intervention is at a minimum level and land and capital are privately owned. Consumers are free to decide what they want to buy and producers are free to produce, within moral standards, what they want and workers are free to choose where and how much to work. The price mechanism is what balances the production and consumption of goods, with the following assumptions made. That firms seek to maximise profits, consumers seek to get the best value for money from their purchases and workers seek to maximise their wages relative to the human cost of working in particular job. This is what Adam Smith referred to as the " Invisible Hand"

The advantages of the free market economy

The fact that a free market economy functions automatically is on of its major advantages. It means that there is no need for costly and complex bureaucracies to co-ordinate economic decisions and therefore the economy can respond quickly to changing demand and supply. Also competition between firms keeps prices down and acts as an incentive to firms to become more efficient. The more firms there are competing, the more responsive they will be to consumer wishes. When there is high competition it stops one person or company from being hugely powerful because there is always a risk that someone will better you.

Problems associated with the free market economy

Competition between firms is often limited. A few giant firms may dominate an industry and could therefore charge high prices and make large profits, rather than merely responding to consumer wishes. By attempting to persuade consumers by advertising they can lead people astray or create a false impression. Consumers are particularly susceptible to advertisements for products that are new to them and of which they have little knowledge.

These are the problems most commonly associated with a free market economy.

Lack of competition and high profits may remove the incentive for firms to be efficient because they may feel that they can rest on their laurels without fear of damaging their profits.
Power and property may be unequally distributed. Those who have power and property will gain at the expense of those without. This could become a vicious circle leading to a large gap in the distribution of wealth.
The practises of some firms may be socially undesirable, while still being profitable.
Some socially desirable goods would simply not be produced by private enterprise although they may be an integral part of our society. E.g. a Lighthouse
A free market economy may lead to macroeconomic instability. There may be periods of recession with high unemployment and falling output, and other periods of rising prices.
Ethical objections, that free market economies, by rewarding self-interest behaviour, may encourage selfishness, greed materialism, and the acquisition of power.

Command Economy
To analyse the effectiveness of the price mechanism we should compare it to its alternative. The command economy has some distinct features, which clearly separates it from the free market.

The command economy works on the principle that instead of having to rely on the decisions of millions of individuals, the government takes an overall view of the economy in the interests of society as a whole. With that view it can direct the nation's resources in accordance with specific national goals.

The thought is that high growth rates could be achieved if the government directed large amounts of resources into investment. Unemployment could be largely avoided if the government carefully planned the allocation of labour in accordance with production requirements and labour skills. National income could be distributed more equally or in accordance with needs. The social repercussions of production and consumption (e.g. the effects on the environment) could be taken into account, provided the government was able to predict these effects.

In practice, a command economy could achieve these goals at considerable social and economic cost.

For example:
A large economy would require a large amount of interpretation from figures, the collection of this information is time consuming and inefficient. Complex plans are likely to have large administration cost and involve cumbersome bureaucracy.
If prices do not reflect the scarcity of the product it is difficult to know if resources are being used efficiently.
Incentives to boost production are likely to result in a drop in quality are therefore would require a large number of officials to check the quality.
Loss of individual liberty as workers would be assigned to jobs rather than having a choice, consumers would only be able to buy certain goods.
The government would have to enforce plans, however unpopular, which it believed to be in the common interest.
If production is planned, but consumers are free to spend income as they wish, problems of shortages and surpluses arise as consumer wishes change.

In practise all economies are a mixture of a command and free economy and it is therefore the degree of government intervention that distinguishes different economic systems.

Consumer Sovereignty

In a capitalistic market economy, consumer sovereignty is a key factor in the effective working of the price mechanism. As Adam Smith said " Consumption is the sole end and purpose of all production and the interest of the producer ought to be attended to only as far as it is necessary for promoting that of the consumer"

In other words, without the consumer the producer is nothing. Consumers are able to vote with their money by offering more of it for products that are in greater demand and less of it for products that are not in demand. Shifts in supply and demand will occur in response to the way in which consumers spend their money.

In competing for consumer's money, producers will produce more of those products, which are in demand, for the prices will be higher, and less of those products that are not in demand, for prices will be lower. Production is the means; consumption is the end.

Those producers, who satisfy the wants of the consumers will be rewarded with large monetary return, those who don't will not remain in business for long.

Consumer's Sovereignty only exists through freedom of choice. Consumers are free to accept or reject whatever is produced in the market place and therefore consumer is king because production ultimately is oriented toward meeting the wants of the consumer

Government intervention

An increase in the power of the state has become a central fact of modern Western society. Crucial decisions about production and distribution have come to be made through the political process rather than through the market place.

Government intervention 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
Taking over production. The government could nationalise various industries or run them directly from government department ( e.g. defence and health)

Regulation various laws have also been passed to regulate the behaviour of firms. For example, various activities, such as the dumping of toxic waste, have been made illegal. 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 unsafe children's toys). We have seen more and more government intervention in the market place from the E.U. as they strive for conformity amongst member nations.

Price Control

Price control is a clear example where government intervention disrupts the price mechanism, all be it for valid reasons.

1) If government sets a minimum price above the equilibrium, there will be a surplus. Price will not be allowed to fall to eliminate this surplus. They would do this to protect producers incomes. If the industry is subject to supply fluctuations (e.g. crops, due to fluctuations in weather) and if industry demand is price inelastic, prices are likely to fluctuate severely. Minimum prices will prevent the fall in producer's incomes that would accompany periods of low prices.

Minimum Price: price floor

The government can use various methods to deal with surpluses associated with minimum prices.
The government could buy the surplus and store it, destroy it, or sell it abroad in other markets.
Restricting products to a particular quota could artificially lower supply.
Demand could be raised buy advertising, or by creating alternative uses for the good

2) If the government sets a maximum price below the equilibrium there will be a shortage. Price will not be allowed to rise to eliminate this shortage. They would do this to create a surplus (e.g. grains) particularly in periods of glut-, which can be stored for possible future shortages.

Maximum price: price ceiling

This would normally be done for reasons of fairness. In wartime, or times of famine, the government may set maximum prices for basic goods so that poor people can afford to buy them. This may however lead to the emergence of black markets, as people are unable to get enough of what they want through the legal markets.

The also government intervenes to stop monopolies in the market place. If it were not to do this it would allow the creation of huge international companies which would have the power to dominate the market and control prices. If this were allowed to happen it would kill of the principle of the price mechanism as companies would stop striving for efficiency, as there would be no need, as they would have no competition.

The government can intervene, in the form of the welfare system, where the results of the price mechanism cause difficulties. For example in the drive for efficiency companies may have to lay off staff to make way for technological advances in the production line, for example robots on car production lines. The government offers unemployment benefit to those who are out of work, this eases the financial burden. They offer opportunities to re-train people for jobs that have a shortage of supply.

They may also offer subsidies to companies' equivalent to the benefits of installing the machines, to keep people employed. The government also encourages companies to set up factories in certain areas by giving them tax incentives. All these things help boost the economy, and make up the difference to create a successful free market economy.


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