Platinum Business Academy
No 106, S De S Jayasingha Mawatha,
Kohuwala, Sri Lanka
Advance Level Cambridge/Edexcel
Price mechanism
The interaction of buyers and sellers in free markets enables goods, services, and
resources to be allocated prices. Relative prices, and changes in price, reflect the
forces of demand and supply and help solve the economic problem. Resources move
towards where they are in the shortest supply, relative to demand, and away from
where they are least demanded.
The rationing function of the price mechanism
Whenever resources are particularly scarce, demand exceeds supply and prices are
driven up. The effect of such a price rise is to discourage demand and conserve
resources. The greater the scarcity, the higher the price and the more the
resource is rationed.
This can be seen in the market for oil. As oil slowly runs out, its price will rise, and
this discourages demand and leads to more oil being conserved than at lower prices.
The rationing function of a price rise is associated with a contraction of demand
along the demand curve.
The signalling function of the price mechanism
Price changes send contrasting messages to consumers and producers about
whether to enter or leave a market. Rising prices give a signal to consumers to
reduce demand or withdraw from a market completely, and they give a signal to
potential producers to enter a market.
Wasim Imtiasz
1|Page
Postgraduate Diploma in Business Administration University of west London, 1st class BA (Hons) Middlesex University (UK),
CIMA passed finalist, ACCA finalist, Edexcel Dual HND in Business & Management + Business & Human Resources (UK)
Platinum Business Academy
No 106, S De S Jayasingha Mawatha,
Advance Level Cambridge/Edexcel
Conversely, falling prices give a positive message to consumers to enter a market
Kohuwala, Sri Lanka
while sending a negative signal to producers to leave a market.
For example, a rise in the market price of 'smart' phones sends a signal to
potential manufacturers to enter this market, and perhaps leave another one.
Similarly, the provision of 'free' healthcare may signal to 'consumers' that they
can pay a visit to their doctor for any minor ailment, while potential private
healthcare providers will be deterred from entering the market. In terms of
the labour market, a rise in the wage rate, which is the price of labour, provides a
signal to the unemployed to join the labour market. The signalling function is
associated with shifts in demand and supply curves.
The incentive function of the price mechanism
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 increasedprofits. The incentive
function of a price rise is associated with an extension of supply along the
existing supply curve.
Wasim Imtiasz
2|Page
Postgraduate Diploma in Business Administration University of west London, 1st class BA (Hons) Middlesex University (UK),
CIMA passed finalist, ACCA finalist, Edexcel Dual HND in Business & Management + Business & Human Resources (UK)
Platinum Business Academy
No 106, S De S Jayasingha Mawatha,
Kohuwala, Sri Lanka
Advance Level Cambridge/Edexcel
Diagram logic
A supply shock reduces supply at each and every price. This creates an
excess of demand at the existing price.
The price is now forced up to a new price (P1) where the market clears.
At the new price, demand and supply are brought into equilibrium through a
contraction of demand (the rationing effect) and an extension of supply (the
incentive effect).
Wasim Imtiasz
3|Page
Postgraduate Diploma in Business Administration University of west London, 1st class BA (Hons) Middlesex University (UK),
CIMA passed finalist, ACCA finalist, Edexcel Dual HND in Business & Management + Business & Human Resources (UK)
Platinum Business Academy
No 106, S De S Jayasingha Mawatha,
Kohuwala, Sri Lanka
Advance Level Cambridge/Edexcel
In the long run, the higher price sends out signals, either for existing firms to
introduce better production methods or by new firms entering the market. This
causes the supply curve to shift to the right. Eventually, price may return to its
existing level.
Wasim Imtiasz
4|Page
Postgraduate Diploma in Business Administration University of west London, 1st class BA (Hons) Middlesex University (UK),
CIMA passed finalist, ACCA finalist, Edexcel Dual HND in Business & Management + Business & Human Resources (UK)