FUNCTIONS OF THE PRICE MECHANISM
i. Determination of what to produce:
The price system determines which goods and services are to be produced. Under the price system, every economic good or service has a price, because it is scarce relative to the demand for it. If there is no demand for a particular good or service, no effort will be exploited to produce it, and if it exists naturally in abundance it will command no price. On the other hand, in spite of existing demand, the commodity will not be supplied if there are no profit prospects due to high cost of production relative to revenue (depending on the level of demand). Thus, market prices of production inputs (costs of production) are considered in relation to the prices at which the commodities can be sold. Consequently, goods and services for which there is sufficient demand and which have relatively higher prices, compared to their average costs of production, would tend to be produced.
ii.Determination of how much to produce
The price system determines the quantities (amounts) of goods and services needed by members of the society. The system is capable of ensuring that resources are allocated fairly enough for firms to produce enough amounts of commodities to meet consumers’ demands. Other things being equal, the greater the total demand for a commodity, the higher its price tends to be. However, the prospect of greater profits due to the higher price will encourage producers to increase future supplies, which tend to bring down the price, and hence a check on the production of future supplies. In this way, the price system determines the quantities of goods and services supplied to meet people’s demands.
iii. Distribution (allocation) of scarce goods and services among consumers:
Once a commodity is given a “price”, the limited quantity of it supplied in any given period is distributed in various amounts among consumers who can afford the price.
The price system rations the limited supply of goods and services among consumers in such a way that the highest bidders, for whom a good has great utility, are able to buy what they want so intensely, while those who think the price is too high are forced to content themselves with other goods they consider a better bargain.
iv. Allocation of scarce factors of production
The prices paid for land, labour and capital similarly distributes the scarce (limited supply of) productive resources among industries or entrepreneurs which are competing for them. Those industries that can offer the highest prices for the factors of production are able to commandeer supplies; while industries which find these prices (rent, wages and interest) too high to yield a profit are forced to contract, giving up the resources in their employment to better-placed industries whose goods are in more urgent demand.
NB
In general, the price mechanism serves to allocate scarce resources to the point where they are scarcest in relation to the wants of consumers (and hence producers).
ADVANTAGES/STRENGTHS OF THE PRICE MECHANISM
i. An efficient, effective and objective means of allocating the economy’s scarce resources
If it is allowed to work in a perfectly competitive environment, the price mechanism would most effectively, efficiently and objectively distribute the economy’s scarce resources among the numerous consumers and producers, and hence among the various geographical and occupational areas of the economy.
ii. Does not require any administrative cost to operate
Allowing the price mechanism to perform its function of resource allocation does not require any expensive administrative machinery or planning. Politicians do not need to make decisions as to what goods and services to produce and how they are to be distributed among consumers and producers.
iii.Promotes consumer sovereignty
The free market system promotes consumer sovereignty; for what is produced (including quantity and quality of goods and services) as well as how, where and when to produce are directed by consumers’ desires and demands.
iv. It encourages initiative
This is because individuals pursue self-interest in a free market system. Producers aim at maximizing profits and so try to attract demand through technical innovations that lead to improvements in the quality and quantity of goods and services. The economy as a whole can experience a dynamic series of innovations and inventions (technological changes) as a result of changes in the conditions of demand and supply which are allowed to operate freely.
v. Prevents shortages, as well as over-supply: The price mechanism prevents shortages, as well as over-supply due to the opportunities of free entry into and exit from production.
vi.Results in the production of a wide variety of goods and services: The system results in the production of a wide variety of goods and services in accordance with the numerous preferences of consumers. That is to say, by means of the price mechanism a vast assortment of goods and services can be produced and distributed in a way which members of the society prefer.
vii. Ensures maximization of the individual’s satisfaction from the use of his income: In a free market situation, the consumer spends his limited income on goods and services in such a manner that he tends to maximize his satisfaction from the use of the income. Given the market prices of commodities, the consumer has the freedom to decide on the amount of each commodity he should buy in order to obtain the “basket of goods” that will yield to him maximum satisfaction relative to his limited income. Under a command economic system, where the price system is not allowed to operate freely, but quantities of commodities are rationed out to consumers, the consumer cannot be said to enjoy maximum satisfaction from the use of his income.
viii.Under perfect competition, the price mechanism will lead to maximization of social welfare. (See “Arguments for Perfect Competition” at section 16 ofTopic 8.2)
DISADVANTAGES (OR DEFECTS) AND LIMITATIONS OF THE PRICE SYSTEM
The price mechanism has its limitations and defects and so a pure price system can never be practised.
i. The system cannot apply in respect of collective goods
The system takes no account of collective or corporate goods, which are necessities but which cannot be brought into the price mechanism. An example of such “goods” is national defence and internal security, which an individual cannot purchase, though he knows they are indispensable, since his country must be protected from foreign aggressors and internal social hazards.
ii. Results in serious inequalities of income opportunities
The pursuit of self-interest leads to inequitable distribution of wealth. To check this situation governments have often interfered with the price mechanism (where it is allowed to operate) by using some income policies to achieve a more equitable distribution of income. In a free competitive system, there is the tendency for producers, who are profit-conscious, to supply output according to “votes cast” (i.e. price offers), which some people (the rich) can do more than others (the poor). Attracted by offers made by the rich, entrepreneurs will produce things needed by the rich (e.g. luxuries).
There is, therefore, the danger of inequality of income generating inequality of opportunities, causing incomes to be progressively more unequal as time goes on.
iii. May lead to the problem of fluctuations in income and unemployment
Allocation of resources by the free operation of the price system will create a situation of rising and declining industries, which will result in problems of fluctuations in income and unemployment.
iv.Private advantage may conflict with social advantage
The price mechanism promotes private benefits irrespective of the social cost involved. It may be necessary for the government to restrict the production of a certain commodity if expansion in production can be achieved only at a heavy social cost. For example, to take the advantage of a higher price of timber, timber-fellers may cause mass disafforestation, which has serious adverse effects on society (e.g. it may lead to soil erosion, drought and bush fires). The government might therefore, be justified to license timber magnates and also to restrict the number of trees that can be felled in a year. A similar thing can be said about the production of socially undesirable goods if in excess (e.g. alcoholic drinks).
v. Inability to bring rapid structural changes in the economy
The price mechanism tends to concentrate on changes in the short run rather than the long run. Left alone therefore, it may lead to a slow rate of economic growth. If a drastic structural transformation of the economy is required, the price mechanism may be either too slow a means or an ineffective means of effecting the needed changes. For example, if a country wants to change over from an agriculture dominated economy to manufacturing economy, the government will have to step in to disturb the price mechanism by reallocating resources.
vi. Not suitable in a period of severe shortage: The price system cannot fairly distribute essential goods during a period of acute scarcity. In time of shortages of essential goods (e.g. food, petrol and soap in wartime,) the price system, left unrestricted, will deny very many people the uses of such indispensable goods. During such times, schemes of rationing, price controls and other measures should be adopted by the government to prevent the price system from working against the obvious advantage of the majority of the population.
THE CONCEPT OF “PRICE” AND ITS FUNCTIONS
Definition of Price: Price is the amount of money paid for, or to be paid for, one unit of a commodity.
Functions of Price
i. The Informative or Signaling Function: The price of a commodity serves as a signal of what is demanded or supplied, providing the information which allows sellers in the market to plan and co-ordinate their economic activities –e.g. a rising price may signal a shortage and this may inform producers to plan for greater production.
ii. The Incentive Function: Price creates an incentive for economic agents (e.g. households and firms) to make decisions and behave in ways that enable them to achieve the fulfillment of their self-interest –e.g. a lower price many induce greater consumption plans, while a higher price may encourage production.
iii.The rationing function: Price rations scarce resources (both consumer and producer goods or services) among competing uses. Once a commodity (a good or service) is given a “price” the limited amount of it supplied in any given period is distributed in various amounts among consumers/producers according to the purchasing ability of each of them.
iv. The Allocative Function: Price distributes (allocates) economic resources (both consumer goods/services and production goods/services) among users in various amounts and forms or kinds. This means the rationing function of price is an aspect of the allocative function. Buyers, for example, would choose between two resources/commodities that can serve the same purpose but differ in terms of quality and, hence price, depending on their purchasing abilities. Those who cannot afford the higher-price commodity are forced to content themselves with the lower-price inferior substitute – e.g. textile materials of widely different qualities. Also, two buyers of the same commodity may purchase different quantities according to their purchasing abilities (other things being equal).
v.The Speculative Function: Speculative business is contingent upon expectations about price changes. If traders expect that the price of an essential item or commodity (e.g. maize, land, a stock-market security) will soon rise, they will tend to buy it now and then resell it when the price has risen. On the other hand, speculators will tend to sell an item now when they expect that its price will soon fall.
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