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 ...