Rationing, signalling and incentives
The interaction of buyers and sellers in free markets enables goods, services, and resources to be allocated prices. Relative prices, and changes in price, reflect the forces of demand and supply and help solve the economic problem. Resources move towards where they are in the shortest supply, relative to demand, and away from where they are least demanded.
The rationing function of the price mechanism
Whenever resources are particularly scarce, demand exceeds supply and prices are driven up. The effect of this is to discourage demand and conserve resources. The greater the scarcity, the higher the price and the more the resource is conserved. This can be seen in the market for oil. As oil slowly runs out, its price will rise, and this discourages demand and leads to more oil being conserved than at lower prices.
The signalling function of the price mechanism
Price changes send contrasting messages to consumers and producers. Rising prices give a signal to consumers to reduce demand or withdraw from a market completely, and they give a signal to producers that they should increase production or enter the market. Conversely, falling prices give a positive message to consumers, to consume more, but a negative message to producers, the produce less. For example, a fall in the price of PCs relative to laptop computers sends a message to producers to manufacture more laptops.
The incentive function of the price mechanism
An incentive is something that motivates a producer or consumer to follow a course of action or to change behaviour. Higher prices provide an incentive to producers to supply more, or to enter the market, because they provide the possibility or more revenue and increased profits. For example, a rise in the wage rate, which is the price of labour, provides an incentive for the unemployed to join the labour market.
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