The price mechanism is a key concept in decision making and operates in a competitive market through the achievement of self-interest. This allows allocation of scarce resources in the best interest of society. This is the essence of the ideology of free market system. In a free market economy with limited government involvement, price mechanism is the organizing force. It functions as a signal and an incentive for producers to act in the required way to maximize their gain, which, in turn, optimizes the allocation of resources.
Everyone in this system is motivated by pure self-interest. Consumers maximize welfare, firms maximize profits and the private individuals aim to maximize the rewards of resources they awn. It is argued that in doing so individuals will be guided as if by an ‘invisible hand’ to achieve maximum social welfare for the nation as a whole. There is consumer sovereignty i.e. through price system, consumers indicate their wishes and community’s productive resources are allocated accordingly. In addition, firms keep production costs as low as possible to obtain highest profit margin. Thus, allocative and productive efficiency will occur. The government’s role is to protect intellectual property rights through patents & copyrights. Hence, there are incentives for firms to be innovative and produce better quality products. Firms also compete with each other on price and always be looking to produce something new to get ahead of their competitors is of no surprise, therefore, that consumers benefit from lower prices, better quality, and a much larger choice of goods and services. In situation of analyzing scarce resources such as capital, the investment ratio such as equity multiplier can be useful.
However, the outcome of price mechanism is undesirable when markets malfunction. Market failure occurs when the signaling and price function mechanism fails to operate optimally leading to a loss of economic and social welfare. For example, Public goods such as streetlights cannot be provided privately because of their two characteristics, non-rivalry and non-excludability. These goods have to be provided publicly or else they will never be produced through price mechanism. Another failure occurs in case of merit and demerit goods. Consumer preferences to consume these goods and services may be based on imperfect information on the costs and benefits. Thus, merit goods, like health and education, tend to be under consumed and demerit goods, like cigarettes and alcohol are over provided.
Also, while responding to price mechanism individual producers base their production decisions on private rather than social costs. Therefore, the market may fail to take into account the external costs and benefits arising from production and consumption. Moreover, in some markets individual preferences may be distorted and shaped by the effects of persuasive advertising and marketing to create artificial wants and needs. On top of these, the system may be judged as ‘unfair’ because there may be considerable inequalities in both income and wealth arising from the operation of price mechanism. Since the wages for labor are determined by the forces of demand and supply, therefore, all those who can afford and obtain better education or are blessed with particular talent, that is high in demand, will be able to command higher incomes and hence, larger share from the nation’s output. Others may not be so fortunate and thus receive far lower incomes and comparatively a lower share from the nation’s output.
Like any other system, the capacity of price mechanism to solve the problem of scarcity is limited. However, the system, by far, seems to be more effective in dealing with the problem yet its effectiveness depends on the degree of failure. Overall, with all its merits, price mechanism does not solve the problem of scarcity but is considered effective in dealing with the problem when operating efficiently.
About the Author
Muhammad Salman Siddiqui is an ACMA and runs his own blog targeting topics on Accounting and Finance at EasyAccounting101.
