Economics – The Price Mechanism What is the Price Mechanism? The Price Mechanism is perhaps the most basic feature of the market economy for allocating resources to various uses. It is the system in a market economy whereby the decisions of producers determine the supply of commodity and the decisions of buyers determine the demand. The interaction between the consumers’ demand for a good and the supply of that good by a producer determine the price.To put more simply; prices are determined by shortages and surpluses. Normally a shortage of a product causes the price to rise, whereas a surplus causes the price to fall. The price will determine how much of a product a producer decides to supply. If the product price is high then profit is greater and more will be supplied due to producer profit motive. If consumers decide that they want more of a good (or if producers decide to cut back supply), then demand will exceed supply. The resulting shortage causes the price to rise. The result is that consumers will be discouraged to buy as much whereas producers will be encouraged to supply more. The price of a good will continue to rise until the shortage has been eliminated. The opposite is true if consumers decide that they want less of a good causing the price to fall until the surplus is eliminated. As this process is continued we can see that there is only one price at which there is neither upward nor downward pressure on price. This is termed the equilibrium price and occurs when demand equals supply.Free Market Economy The price mechanism can only function fully within a free market economy thereby ensuring the allocation of all resources without the need for government intervention. A free market economy exists where government intervention is minimal, land and capital are privately owned, consumers are free to decide what they want to buy and producers are free to produce any good. Also workers are free to ...
