This article talks about three main functions of price – rationing, signaling and incentives. It explains how these functions of price influence the market system. This post also introduces briefly what is meant by Adam Smith’s ‘Invisible Hand’ and explains the advantages of the market system.
The role of the market
The market system is used to freely produce, distribute and consume wealth and resources within the economy. Within this system there are several economic agents including the following:
- Consumers – Users of goods and resources.
- Producers – Makers of goods and resources.
- Owners – Owners of factors of production.
- Government – The manager of the economy.
Consumers and producers communicate in the consumer goods markets, e.g. mobile phones, restaurants and drinks. And producers and owners communicate in factor markets. Factor markets are markets for a factor of production; e.g. labor, capital or land, mainly commodities – raw materials or agricultural products.
Adam Smith’s ‘Invisible Hand’
Adam Smith’s ideas were aimed at changing the restrictive practices of rulers at the time. Many economists consider him and his ideas to be the ‘father of modern economics’.
The main idea of Adam Smith stated that people are motivated by ‘self-interest’. Self-interest is concern for your own interests and welfare. Therefore, consumers choose the lowest price and producers choose the highest rate of profit.
When surpluses and shortages are known, consumers ‘direct’ investments to the most profitable industry. This process works best in a society where information over what is produced is highly available. Therefore, ‘consumer sovereignty’ is essential. If consumers are not ‘the kings’ who make final choices, then they cannot affect producers’ production choices with their demand or acceptance of price.
Society also needs a degree of law and morality. Although, he was a supporter of the free market, Adam Smith saw value in governmental involvement. It is the government which is charged with the task of creating laws to protect the economic agents.
The 3 functions of price
The functions of price are rationing, signalling and incentive.
1. Rationing
Rationing helps allocate products efficiently among customers when supply is scarce. Consumers’ wants are infinite; no matter what individuals have they always want more. This is a problem because most resources are scarce. A function of price is to ‘ration’ scarce resources. If a good is scarce, its price will be high, whilst abundant or less scarce resources will have a lower price.
2. Signaling
Signaling is how price conveys information to producers – passes on info. If the price is high, it tells producers it is worthwhile using resources to produce that particular good as a shortage exists in the market. If they fill this shortage they can make a profit since they know excess demand exists.
Price also acts as a signal to consumers as it informs consumers what product is high in demand. This is often true for goods which are considered cool, of good quality, rare, a combination of these factors, etc. An increasing price as an indicator of rarity may encourage people to buy before it is unavailable or out of their price range. Falling prices may be a signal that the product is not as desirable as it once was – perhaps there is more competition or a change of technology, leading to newer, improved products becoming available.
3. Incentives
Incentive is something which motivates an action. Price acts as an incentive because if a good is cheaper consumers will be willing and able to buy more. The benefits of the products have better value at a lower price. The incentive is different for the producer, as a higher market price acts as an incentive for producers to allocate resources to making a product, thereby increasing their supply.
In summary, Adam Smith’s ‘Invisible Hand‘ explains how market forces work together unintentionally for the benefit of the society. The function of price is to ration scarce resources, signal to producers and consumers worth and quantity as well as offer incentives for buyers and producers.
