The price mechanism (price system) refers to the process by which prices are determined by
the free operation of the forces of demand and supply. Through the price system, also called
“the free market system”, allocation of factors of production and distribution of goods and
services are made on the basis of relative prices; for under the free market system, consumers
base their expenditure plans and producers base their production plans on relative market
prices. The price-mechanism would produce a perfect or an ideal allocation of resources (both
factors of production and consumption goods and services) if market conditions in the
economy were perfectly competitive.
While a capitalist economy is a congenial environment for the free market system, a centrally planned economy is opposed to the free functioning of the price mechanism.
Under a centrally planned (socialist) system, price decisions are taken by the central authority. In the real world situation, the price mechanism plays a partial role, with varying degrees, in the (i.e. not solely responsible for the) determination of prices and in the allocation of resources in any economy, since even in capitalist economies, governments have often interfered with the free market system, by influencing either directly or indirectly the prices of certain goods and services.
CONDITIONS FOR THE FREE OPERATION OF THE PRICE SYSTEM
The price mechanism would operate perfectly under the following conditions:
i. ?Where perfect competition exists in the economy: The more competitive is the economy the greater is the extent to which the price mechanism can function.
ii.?Producers and consumers must act rationally in the sense that producers must aim at maximizing profits and consumers must buy from the cheapest source, and if some firms are more efficient and have lower costs than others, they will be in a position to charge lower prices. Inefficient firms will therefore not be able to obtain the higher prices necessary to cover their higher costs and will sooner or later go out of business.
iii.?Both consumers and producers pursue self-interests, which lead consumers to maximize their satisfaction with no regard to social or ethical consequences, and producers to maximize their profits with no regard to the social or ethical consequences of their actions.
iv.?No government controls or interferences: There should be no government actions such as price controls, tax imposition and subsidy offers in the market.
HOW THE PRICE MECHANISM OPERATES
Given the necessary conditions as outlined above, the operation of the price mechanism can be explained as follows: The expenditures of consumers constitute the receipts of producers, and so whenever a consumer spends money on a particular commodity he is indirectly “casting a vote” for its production rather than another, by providing an incentive for the producers of the particular commodity to supply more of it.
Consider a situation where consumers are spending their incomes (which are limited) on a wide range of products, and assume that the producers of each product are earning just sufficient revenue to cover their costs, and no more. Also suppose consumers’ tastes change in favour of a commodity X, but to the disadvantage of another commodity Y, so that they buy more of X but less of Y.
This situation will result in a fall in the priceof Y, and hence a fallin the revenue to the producers of Y, but a rise in the price and hence revenue to the producers of X.
Consequently, for producers of Y, revenue will no longer cover costs of production (assuming costs remain unchanged) and this will force some of the producers out of the industry, creating unemployment of resources in the industry. For producers of X, however, the increase in revenue and hence in profits will cause resources displaced in industry Y to be switched to produce more X. Through price or profit incentives due to the increase in demand in industry X, therefore, the output composition of X and Y has been remoulded to suit the tastes of customers. Thus without any planning by the central authority, the allocation of resources is automatically achieved by the price mechanism through appeals to the self-interests of consumers and producers. Adam Smith called the price mechanism “the invisible hand of the market”, and said it should ensure that the self interests of entrepreneurs in pursuing profits would lead to the right commodities being produced in the relative quantities desired by consumers.
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