Adam Smith, one of the Founding Fathers of economics famously wrote of the “invisible hand of the price mechanism”. He described how the invisible or hidden hand of the market operated in a competitive market through the pursuit of self-interest to allocate resources in society’s best interest. This remains the central view of all free-market economists, i.e. those who believe in the virtues of a free-market economy with minimal government intervention.
The price mechanism is a term used to describe the means by which the many millions of decisions taken each day by consumers and businesses interact to determine the allocation of scarce resources between competing uses. This is the essence of economics!
Firstly, prices perform a signalling function. This means that market prices will adjust to demonstrate where resources are required, and where they are not.
Prices rise and fall to reflect scarcities and surpluses. So, for example, if market prices are rising because of high and rising demand from consumers, this is a signal to suppliers to expand their production to meet the higher demand.
Consider the left hand diagram on the next page. The demand for computer games increases and as a result, producers stand to earn higher revenues and profits from selling more games at a higher price per unit. So an outward shift of demand ought to lead to an expansion along the market supply curve
In the second example on the right, an increase in market supply causes a fall in the relative prices of digital cameras and prompts an expansion along the market demand curve
Conversely, a rise in the costs of production will induce suppliers to decrease supply, while consumers will react to the resulting higher price by reducing demand for the good or services.
The transmission of preferences
Through the signalling function, consumers are able through their expression of preferences to send important information to producers about the changing nature of our needs and wants. When demand is strong, higher market prices act as an incentive to raise output (production) because the supplier stands to make a higher profit. When demand is weak, then the market supply contracts. We are assuming here that producers do actually respond to these price signals!
One of the features of a free market economy is that decision-making in the market is decentralised in other words, the market responds to the individual decisions of millions of consumers and producers, i.e. there is no single body responsible for deciding what is to be produced and in what quantities. This is a remarkable feature of an organic market system.
The rationing function
Prices serve to ration scarce resources when demand in a market outstrips supply. When there is a shortage of a product, the price is bid up – leaving only those with sufficient willingness and ability to pay with the effective demand necessary to purchase the product. Be it the demand for tickets among England supporters for the 2006 World Cup or the demand for a rare antique, the market price acts a rationing device to equate demand with supply.
The prices for using the M6 Toll Road are a good example of the rationing function of the price mechanism. A toll road can exclude those drivers and vehicles that are not willing or able to pay the current toll charge. In this sense, motorists and road haulage businesses and other road users are paying for the right to use the road, road space has a market price instead of being regarded as something of a free good. The current charges are below:
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