Economics » Theory of Price Determination » Functions of the Price System

Functions of the Price System

Functions of the Price System

1) Output Determination:

The price system gives the ultimate decision to consumers as to what goods and services will be produced. Every time a consumer makes a purchase, it is like registering a vote in favour of the continuing production of that article.

If consumers’ demand for a particular article increases rapidly, there will be a shortage of supplies in the shops. Scarcity will cause a rise in price. This will have two effects. First, the price increase will ration out the quantity available by reducing the number of buyers. Secondly, the prospect of greater profits will encourage producers to increase supplies.

A falling off in demand by consumers will have the opposite effect. Sellers will reduce their prices in an effort to clear their stock and a fall in price will also have two effects. First, profits will fall and may even become zero or negative, in which case, production will be stopped. Hence, supplies will diminish. Secondly, demand will increase because consumers will be willing to buy more at lower prices.

Thus, consumers’ demand, acting through the price system, determines the assortment and quantity of goods produced.

2) Resource Allocation:

The second function of the price system is the distribution of scarce resources among competing producers. Those industries which can offer the highest prices for the factors of production are able to attract supplies. On the other hand, industries which find the factor prices too high to yield a profit from manufacturing are forced to contract.

For example, if consumers decide that they want more gloves than is currently being manufactured, and fewer shoes, there will be an increased demand for the stock of gloves on the market and a slackening of demand for shoes. As a result, the price of gloves will rise as consumers seek to buy more of them than are available and shoe prices will tend to fall as the public decide against buying more shoes. When glove prices rise, profits in that industry will rise too and as shoe prices fall, profits in that industry will fall.

Consequently, workers will be released from the shoe factories as output contracts and will move to the glove business where more workers will be required to produce a greater supply of gloves. Through the price mechanism, society has changed the allocation of its productive resources to fit its new desires.

3) Organisation of Production:

The third function of the price system is to determine who should produce goods and services and which methods of production should be used. These matters are decided by competition among different producers. Those who are more efficient because their costs of production are lowest will succeed in supplying a commodity at a lower price than their competitors. The inefficient will be forced to go out of business. In a similar way, competition determines the methods of production used. The chosen methods of production will be those by which costs are reduced to the minimum.

4) Income Distribution:

Income is earned either by some form of labour or it is derived from the ownership of property. The amounts of these incomes are determined by the conditions of demand and supply in the markets for land, labour, and capital.

If demand for a product is rising, firms engaged in its production will expand, their demand for factors of production will increase, and the incomes of the factors will rise. Conversely, if consumers’ demand for a product is declining, then the incomes of factors engaged in producing that product will tend to fall.

5) Information Transmission:

The price system transmits information to the people who need to know. If there is a boom in one sector of the economy, shopkeepers selling these products will increase their orders to the manufacturers and, in order to persuade manufacturers to supply more goods, they will probably have to pay higher prices. This will induce the suppliers to increase their work force – or make it possible for them to pay overtime rates of pay. All the people involved in this market will be aware of the change in prices. The information will be of no interest to those in different markets and will be ignored by them.

[Attributions and Licenses]

This is a lesson from the tutorial, Theory of Price Determination and you are encouraged to log in or register, so that you can track your progress.

Log In

Share Thoughts