System of interdependence between supply of a good or service and its price. It generally sends the price up when supply is below demand, and down when supply exceeds demand. Price mechanism also restricts supply when suppliers leave the market due to low prevailing prices, and increases it when more suppliers enter the market due to high obtainable prices. Also called price system.

Price Mechanism: An Overview

The price mechanism is a fundamental concept in economics that plays a crucial role in determining the allocation of resources within an economy. It refers to the system through which prices of goods and services are determined based on the forces of supply and demand. The price mechanism acts as a signaling device, coordinating the decisions of buyers and sellers in the market.

How Does the Price Mechanism Work?

The price mechanism operates through a series of interactions between buyers and sellers in a market. These interactions are guided by the forces of supply and demand, which influence the equilibrium price and quantity of a good or service. Here is a step-by-step breakdown of how the price mechanism works:

1. Supply and Demand: The price mechanism starts with the presence of both supply and demand for a particular good or service.
2. Market Equilibrium: The equilibrium price and quantity are determined by the intersection of the supply and demand curves. At this point, the quantity demanded equals the quantity supplied.
3. Price Signals: Prices serve as signals to both buyers and sellers. A higher price indicates scarcity or increased demand, while a lower price implies excess supply or reduced demand.
4. Incentives: Higher prices incentivize producers to increase their output as it becomes more profitable. Conversely, lower prices discourage production.
5. Allocation of Resources: The price mechanism ensures that resources are allocated efficiently. When prices rise due to increased demand, resources are directed towards the production of the desired goods or services. Conversely, when prices fall, resources are shifted away from the less demanded products.
6. Market Forces: Changes in market conditions, such as shifts in supply or demand, affect prices. For instance, if demand increases, it leads to higher prices and vice versa.
7. Equilibrium Adjustments: If there is an excess supply or demand in the market, prices adjust to restore equilibrium. If there is excess supply, prices will fall until demand matches supply. Conversely, if there is excess demand, prices will rise until supply meets demand.
8. Market Efficiency: The price mechanism helps in achieving market efficiency by allowing resources to flow freely to their most valued uses. It encourages competition and innovation, as producers strive to offer better products at competitive prices.

Conclusion

In summary, the price mechanism acts as a vital coordinating mechanism in an economy. It uses the forces of supply and demand to determine prices and allocate resources efficiently. By continuously adjusting prices in response to changing market conditions, the price mechanism ensures that resources are allocated optimally, leading to the efficient functioning of markets.