Question: Explain the role of the price mechanism in allocating resources in an economy

As resources are scarce relative to the insatiable demands of human wants, economies are concerned with basic questions of allocation. The free market price mechanism (is the forces of demand and supply) answers the questions of- What and how much to produce? For whom to produce? How to produce?

In a market, resources are allocated based on the demand/supply in which prices plays an signalling function as it allocates resources to the production of different types of goods. It also acts as signalling mechanism between buyers and sellers; telling them how much and what to produce.

What and how much to produce?

Resources are limited and cannot produce enough goods and services to satisfy human wants which are unlimited.
The economy must make a choice on the types of goods and services that it wants to make available to the country. For example, an economy has to decide on the different types of goods to produce, determined jointly by producers and consumers through the signalling role of prices and their self-interest. Price shows how much consumers are willing and able to pay, signalled by the demand curve. How much producers are willing and able to produce, is shown by supply curve

In this way, the price acts as a signal telling the producers what to produce and how much of the good to produce.

Price and Demand diagram

Thus determines the allocation of resources among various goods. If  market is in disequilibrium, the market will adjust until equilibrium price and quantity achieved a satisfaction of both buyers and sellers maximised. For example, when Qd < Qs for rice, ceteris paribus, a shortage results. There will be upward pressure on the price and the price increase will signal an increase in profit which leads to a reallocation of resources into the production of that good.

For whom to produce?

Price mechanism also shows who to produce these resources for. This is shown by the demand curve which signifies consumers’ willingness and ability to pay. In a way it represents their economic dollar votes and shows that producers should produce for these consumers.

Resources are scarce, no society can satisfy all the wants of its people.
How the limited supply of final goods/services produced is allocated among people?
Price acts as a mechanism in a market economy and distributes the output only to people who are able and willing to pay for the good.

This in turn depends on the purchasing power and the value that people place on the good. Consumers pay and consume goods to maximise consumer welfare while producer try to maximise profits. Using the DD/SS diagram above, the equilibrium output at Qe will be allocated to consumers who are willing and able to pay at least the equilibrium price which is set at Pe.

How to produce?

Prices of resources and factors of production also address the question of how to produce various goods and services. An economy can choose to produce using use various factors of production like labour (human) or capital (machines). Price of resources should guide firms’ production methods and firms choose resources that are cheapest and incur the lowest opportunity cost.

In the factor market the producers demand for resources and the consumers are factor owners that supply the resources.  The allocation of resources among the competing uses is based on the prices of the resources.

For example, a manufactured good can either be produced by capital intensive methods (where there is little use of labour and greater use of machines) which are more efficiency or labour intensive methods (where greater use is made of labour).

A firm’s main aim is to reduce the cost of production as guided by relative prices of factors of production. In countries like China, where resources like LAND and LABOUR are abundant, they tend to be engaged in labor intensive production due to and it is easier to produce using such methods.