Role Of Price Mechanism

Custom Student Mr. Teacher ENG 1001-04 30 May 2016

Role Of Price Mechanism

The role of price mechanism in a free market economy or capitalism! The price system functions through prices of both goods and services. Prices determine the production of innumerable goods and services.

They organise production and help in the distribution of goods and services, ration out the supplies of goods and services and provide for economic growth. Let us analyse the role of prices in all these spheres.

(1) What and How Much to Produce:

The first function of prices is to resolve the problem of what to produce and in what quantities. This involves allocation of scarce resources in relation to the composition “of total output in the economy. Since resources are scarce, the society has to decide about the goods to be produced: wheat, cloth, roads, television, power, buildings, and so on. Once the nature of goods to be produced is decided, then their quantities are to be decided. How many kilos of wheat, how many million metres of cloth, how many kilometers of roads, now many televisions, how many million kw of power, how many buildings, etc. Since the resources of the economy are scare, the problem of the nature of goods and their quantities has to be decided on the basis of priorities or preferences of the society.

If the society gives priority to the production of more consumer goods now, it will have less in the future. A higher priority on capital goods implies less consumer goods now and more in the future. This problem can be explained with the help of the production possibility curve, as shown in Figure 7.1. Suppose the economy produces capital goods and consumer goods. In deciding the total output of the economy, the society has to choose that combination of capital and consumer goods which is in keeping with its resources.

It cannot choose the combination R which is inside the production possibility curve PP, because it reflects economic inefficiency of the system in the form of unemployment of resources. Nor can it choose the combination K which is outside the current production possibilities of the society. The society lacks the resources to produce this combination of capital and consumer goods. It will have, therefore, to choose among the combinations B, C or D which give the highest level of satisfaction. If the society decides to have more capital goods, it will choose combination B and if it wants more consumer goods, it will choose combination D.

(2) How to Produce:

The next task of prices is to determine the techniques to be used for the production of articles. Prices of factors are the rewards received by them. Wage is the price for the service of labour, rent is the price for the service of land, interest for the service of capital and profit for the service of entrepreneur. Thus wages, rent, interest and profit are the prices paid by the entrepreneur for the services of the factors of production which make up the costs of production. Every producer aims at using the most efficient productive process. An economically efficient production process is one which produces goods with the minimum of costs. The choice of a production process will depend upon the relative prices of the factor services and the quantities of goods to be produced. A producer uses expensive factor services in smaller quantities relative to cheap resources.

In order to reduce costs of production, he substitutes cheaper resources for the dearer. If capital is relatively cheaper than labour, the producer will use a capital-intensive production “process. Contrariwise, if labour is relatively cheaper than capital, labour-intensive production processes will be used. The technique to be used also depends upon the type and quantity of goods to be produced. For producing capital goods and large outputs, complicated and expensive machines and techniques are required. On the other hand, simple consumer goods and small outputs require small and less expensive machines and comparatively simple techniques.

(3) To Determine Income Distribution:

The price mechanism also determines how income is distributed in a capitalist economy. In such an economy, consumers and producers are largely the same people. Producers “sell goods at given prices to consumers for money, and consumers receive “incomes from producers in exchange for their services. The owners of factors of production who are all consumers sell their services at given prices for money to producers, and then spend that money to buy goods produced by producers. In fact, the price mechanism is a system of real flows from producers to consumers and from consumers to producers. This figure shows the price mechanism in the form of a circular flow. The upper portion determines the prices on the goods market when the demand for goods by consumers equals the supply of goods by producers.

It is this which decides what to produce. The decision as to how to produce is entirely taken by the producers. The lower portion of the figure shows that consumers or households are the controllers of the factors of production—land, labour, capital and entrepreneurial talent. It is they who supply their services to producers who demand them and in return the households receive money. This is how prices are determined on the factor market.


Thus the price mechanism working through supply and demand in a free enterprise economy acts as the principal organising force. It determines what to produce and how much to produce. It determines the rewards of the factor services. It brings about an equitable distribution of income by causing resources to be allocated in right directions. It works to ration out the existing supplies of goods and services, utilises the economy’s resources fully and provides the means for economic growth.

Price Mechanism in a Socialist or Controlled Economy:

In a socialist economy, the decisions as to what, how and for whom to produce are not guided by the price mechanism as under a capitalist economy. Instead, they are made by the central planning board assisted by the various ministries, industries and state enterprises. Thus it is the central planning board that performs the functions of the market. The decisions as to what to produce and in what quantities are based on the objectives, targets and priorities laid down in the plan. The central planning authority decides, for example, if more bicycles are to be produced than cars, or houses for the masses more than hotels, or more eggs are to be produced than chocolates. It also fixes prices for all commodities. They are administered prices at which commodities are sold in state-run stores throughout the country. Administered prices are fixed arbitrarily by the central planning board without calculating the actual cost of production of commodities. Prices can be reduced or increased only by the central planning authority. People buy commodities according to their preferences and incomes.

The decision as how to produce different commodities is also taken by the central planning authority. The latter allocates resources and decides which methods of production to employ. What share of the factors of production should be allocated to the production of capital goods and what share to the production of consumer goods? The planning board lays down two rules for the guidance of plant managers. One, each manager should combine productive goods and services in such a manner that the average cost of producing a given output is the minimum. Two, each manager should choose that scale of output which equalises marginal cost to price. He must see to it that the industry produces exactly as much of a commodity as can be sold at a price which equals the marginal cost. In a socialist economy, raw materials, machines and other inputs are sold by public enterprises at prices which are equal to their marginal cost of production.

So pricing in a socialist economy is based on the marginal cost pricing like that in a capitalist economy. If the price or cost of a commodity is above its average cost, the plant managers will earn profits and if it is below the average cost of production, they will incur losses. In the former case, the industry would expand and in the latter case it would cut down production. Ultimately, a position of equilibrium will be reached where price equals both the average cost and the marginal cost of production. But since goods are produced in anticipation of demand, it is accounting prices which are the basis of price determination. This, in turn, depends on the process of trial and error which necessitates small adjustments in prices from time to time. The problem for whom to produce is also solved by the state in a socialist economy. The central planning authority takes this decision at the time of deciding what and how much to produce in accordance with the overall objectives of the plan.

In making this decision, social preferences are given weight-age. In other words, higher weight-age is given to the production of those goods and services which are needed by the majority of the people over luxury items. They are based on the minimum needs of the people, and are sold at fixed prices through government stores. Since goods are produced in anticipation of demand, an increase in demand brings about shortages and this leads to rationing. The problem of income distribution is automatically solved in a socialist economy because all resources are owned and regulated by the state. All interest, rent and profit are fixed by the state and go to the state exchequer. As regard wages, they are also fixed by the state according to the amount and quality of work done by an individual. Each individual is paid according to his ability and work. Economic surpluses are deliberately created and invested for capital formation and economic growth.

Price Mechanism in a Mixed Economy:

A mixed economy solves the problem of what to produce and in what quantities in two ways. First, the market mechanism (i.e. forces of demand and supply) helps the private sector in deciding what commodities to produce and in what quantities. In those spheres of production where the private sector competes with the public sector, the nature and quantities of commodities to be produced are also decided by the market mechanism. Second, the central planning authority decides the nature and quantities of goods and services to be produced where the public sector has a monopoly. In the case of consumer and capital goods, commodities arc produced in anticipation of social preferences. Prices are fixed by the central planning authority on the principle of profit-price policy. There are administered prices which are raised or lowered by the state. For public utility services like electricity, railways, water, gas, communications, etc., the state fixes their rates or prices on no-profit no-loss basis.

The problem of how to produce goods and services is also solved partly by the price mechanism and partly by the state. The profit motive determines the techniques of production in the private sector. At the same time, the central planning authority intervenes and influences the working of the market mechanism. The state guides and provides various facilities to the private sector for adopting such techniques of production which may reduce costs and maximise output. It is the state which decides where to use capital-intensive techniques and where to use labour-intensive techniques in the public sector. The problem for whom to produce is also decided partly by the market mechanism and partly by the central planning authority.

In the private sector, it is the market mechanism which determines what goods and services are to be produced on the basis of consumer preferences and incomes. Since a mixed economy aims at achieving growth with social justice, the allocation of resources is not left entirely to the market mechanism. The state intervenes to allocate resources “and for the distribution of income. For this, it adopts social security programmes and levies progressive taxes on income and wealth. In the public sector, the state decides for whom to produce in anticipation of consumer preferences.


  • Subject:

  • University/College: University of Chicago

  • Type of paper: Thesis/Dissertation Chapter

  • Date: 30 May 2016

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