1. The signalling function:
Prices perform a signalling function. This means that market prices will adjust to demonstrate where resources are required, and where they are not. Prices rise and fall to reflect scarcities and surpluses. So, for example, if market prices are rising because of high and rising demand from consumers, this is a signal to suppliers to expand their production to meet the higher demand.
2. The transmission of preferences
Through the signalling function, consumers are able through their expression of preferences to send important information to producers about the changing nature of our needs and wants. When demand is strong, higher market prices act as an incentive to raise output (production) because the supplier stands to make a higher profit. When demand is weak, then the market supply contracts. We are assuming here that producers do actually respond to these price signals!
One of the features of a free market economy is that decision-making in the market is decentralised in other words, the market responds to the individual decisions of millions of consumers and producers. That is to say; there is no single body responsible for deciding what is to be produced and in what quantities. This is a remarkable feature of an organic market system.
3. The rationing function
Prices serve to ration scarce resources when demand in a market outstrips supply. When there is a shortage of a product, the price is bid up – leaving only those with sufficient willingness and ability to pay with the effective demand necessary to purchase the product.
The price mechanism is the only allocative mechanism solving the economic problem in a free market economy. However, most modern economies are mixed economies, comprising not only a market sector, but also a non-market sector, where the government (or state) uses the planning mechanism to provide public goods and services such as police, roads and merit goods such as education, libraries and health.
In a state run command economy, the price mechanism plays little or no active role in the allocation of resources. Instead government planning directs resources to where the state thinks there is greatest need. The reality is that state planning has more or less failed as a means of deciding what to produce, how much to produce, how to produce and for whom. Following the collapse of communism in the late 1980s and early 1990s, the market-based economy is now the dominant economic system – even though we are increasingly aware of imperfections in the operation of the market – i.e. the causes and consequences of market failure.
- Prices and incentives:
Price incentives matter enormously in our study of microeconomics, markets and instances of market failure. For competitive markets to work efficiently all economic agents (i.e. consumers and producers) must respond to appropriate price signals in the market.
Market failure occurs when the signalling and incentive function of the price mechanism fails to operate optimally leading to a loss of economic and social welfare. For example, the market may fail to take into account the external costs and benefits arising from production and consumption. Consumer preferences for goods and services may be based on imperfect information on the costs and benefits of a particular decision to buy and consume a product. individual preferences may also be distorted and shaped by the effects of persuasive advertising and marketing to create artificial wants and needs.
- Government intervention in the market:
Often the incentives that consumers and producers have can be changed by government intervention in markets. For example a change in relative prices brought about by the introduction of government subsidies and taxation. The “law of unintended consequences” encapsulates the idea that government policy interventions can often be misguided of have unintended consequences !In a market economy, price is the aggregation of information acquired when people are free to use their individual knowledge. Price then allows everyone dealing in a commodity or its substitutes to make decisions based on more information than they could personally acquire, information not statistically conveyable to a centralized authority. Interference from a central authority which affects price will have consequences; central authority or government could not foresee because they do not know all of the particulars involved.