How the interaction of demand and supply determine the price and quantities of the goods that get produced.
This price mechanism has three individual functions that it performs:
- The first is the rationing function which enables prices to change in order to curb or encourage demand in order to cope with limited or excess supply. This often happens for the demand for sporting event tickets.
- Then there is the signalling function which means that prices are there to inform economic agents about market fluctuations i.e. if the price of a good is high this signals to producers that this good is in high demand and therefore they should produce more.
- Finally, prices have an incentive function which provides agents with the incentives to change their behaviour i.e. firms are incentivised to produce more goods if the price is high due to higher margins and profit incentives.
Below is a brief summary of these functions of the price mechanism.
