Notes on Functions of Price (Price Mechansim)

1) Signalling Function:

"Information" to the producers.

Higher price signals shortage exists in the market.

Lower price signals surplus.

2) Incentive Function:

For Producers, higher price means higher profit margins, ceteris paribus. Thus, there is a greater incentive to produce more to earn more profits, leading to increase in quantity supplied (as per the Law of Supply). The converse is true (when prices fall).

Also, if price of a particular factor of production increases, firms will be less incentivised to utilise that factor and will consider switching to other factor of production (fop). Profit-maximising firms will seek to produce using least-cost methods of production and hence the higher price of fop incentivises the firms to use less of that FOP and more of others.

For Consumers, higher price incentivises them to consider other alternatives. This leads to fall in quantity demanded (as per law of demand). The converse is true (when prices fall).

3) Rationing Function:

This occurs under the scenario of rising prices (due to shortage). Some consumers will now be unable and/or unwilling to pay the higher prices and stop demanding for the good. In that way, the higher prices serve as a rationing tool - only those who are able and willing to pay the higher prices will get the good. Ultimately, those who are most able and willing to pay will get the good.

Yes SIR !

You will be required to explain these functions as part of the workings of the Price Mechanism. Through these workings, the free market or price mechanism will serve to allocate resources and answer the 3 Key Economic Questions:

1) What and How much to produce

2) How to Produce

3) For Whom to Produce

You should use the above explanations together with the Market Adjustment Process explanations to show how the price mechanism work. See a sample model essay here. To get your hands on my concise and accurate JC A Level and IB Economics notes, join our economics tuition programme today!