The Price Mechanism Explained

'The Invisible hand' theory was created by famous economist Adam Smith. The theory is described as the “invisible hand of the price mechanism” in which the hidden-hand of the market operating in a competitive market through the pursuit of self-interest allocated resources in society’s best interest.

3 main functions of the Price Mechanism:

1) Rationing function:

• In a market of scarce resources, price acts as a control on the allocation of these resources when demand is greater than supply.
• When there is a shortage in a good or service, price is increased, leaving only those who are able or are willing to pay the raised price. This hopes to re-find the balance between demand and supply.

2) Signalling Function

• Prices are able to form a signalling function; where price adjusts to demonstrate where resources are required, and where they are not.
• This means that price increases and decreases reflect shortages and surpluses of goods/services.

3) Incentive Function

• When consumers make choices, they send information to producers about changes in preferences and demand in certain goods.
• Higher prices act as an incentive to raise output because the supplier stands to make a better profit.
• When demand is weaker in a recession then supply contracts as producers cut back on output.