The role of the price mechanism in resource allocation

In economics, the Price mechanism refers to the invisible hand of demand and supply. It is seen to be one that answers the economic questions of what to produce, how to produce and for whom to produce. The need for price mechanism arises from the central problem of economics: scarcity. Since there are limited resources and infinite wants, there is a need to allocate resources in a way that maximizes economic welfare. The forces of demand and supply can be represented below.

Price and Demand diagram

The price mechanism serves as a signaling function for the free market thus market prices will adjust to demonstrate where resources are required, and where they are not. The rise and fall of prices reflect shortages and surpluses.

For example, when the prices are too high, at B, the quantity supplied of cars exceed quantity demanded. There is a surplus and a downward pressure on price as producers try to reduce their excess stock. The price thus moves down towards A. If however, the price was too low, say C, the quantity demanded of cars exceed the quantity supplied, there is a shortage which creates an upward pressure on price. More resources such as labour and capital will then be allocated to production of cars. The rising demand for the labour and capital resources to produce cars will cause the price of these resources to increase in the factor market.

Hence, if prices are too high, they drop. If prices are too low, they rise. Eventually they settle at the equilibrium price A, where qty DD=qty SS, the market clears at this price and there is no tendancy to change.

Thus, price mechanism serves as an allocative mechanism telling producers what to producer.

Through the signalling function, it also answers the question of for whom to produce. Price (dollar votes) answers the question of for whom the goods should be produced for. In answering the resource allocation question of for whom to produce, resource allocation via the price mechanism is geared towards whoever can pay, ie consumers willing and ability to pay at given price. 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 and resources will be moved out of the market. From the diagram above, the movements in the consumers demand curve cause change in the equilibrium output in this market, which effectively tells producers the amount to produce and which consumers are demanding for this item (through the demand curve which shows their willingness and ability to pay for the good)

As for how to produce, price of factors of production acts as a signal to producers when deciding how to produce. The traditional aim of producers is to maximise profits. As such, they will seek for the lowest cost method of production. For instance, in Singapore whereby the price of labour has increased relative to capital, producers will use more capital-intensive method of production. With least-cost method being employed in the production, productive efficiency can be achieved.

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