Price Mechanism

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FUNCTIONS OF PRICE MECHANISM

1.Signalling function: prices perform a signalling function. They adjust to demonstrate where resources are required, and where they are not. Prices rise and fall to reflect scarcities and surpluses. If prices are rising because of high demand from consumers, this is a signal to suppliers to expand production to meet the higher demand. If there is excess in the market, the price mechanism will help to eliminate a surplus of goods by allowing the market price to fall.

1.The Incentive Function: This function is also refer to as the signalling function. An incentive is something that motivates a producer or consumer to follow a course of action or to change behaviour. Higher prices provide an incentive to existing producers to supply more because they provide the possibility or more revenue and increased profits. The incentive function of a price rise is associated with an extension of supply along the existing demand curve. On the other hand, when the price of a product falls, it will serve as inducement for consumers of such product to increase their demand for it, this is because the consumers will see it as an opportunity to have more of the product at a relatively cheaper price. In a nutshell therefore, the price mechanism serve as an incentive or a tool of signalling for both the producers and the consumers in their way of deciding the quantity of what to be produce and the quantity to be demanded for respectively.

In the 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.

1.Transmission of preferences: through their choices, consumers send information to producers about changing nature of needs and wants. Higher prices act as an incentive to raise output because the supplier stands to make a better profit. When demand is weaker in a recession, then supply contracts as producers...
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