Edexcel A Level Economics A:复习笔记1.2.7 Price Mechanism

Functions of The Price Mechanism

  • The price mechanism is the interaction of demand and supply in a free market
    • This interaction determines prices which are the means by which scarce resources are allocated between competing wants/needs
  • The price mechanism fulfils three functions in the relationship between buyers and sellers
    • Rationing: prices allocate (ration) scarce resources. When resources become scarcer the price will rise further. Only those who can afford to pay for them will receive them. If there is a surplus then prices fall and more consumers can afford them
    • Signalling:  prices provide information to producers & consumers where resources are required (in markets where prices increase) & where they are not (in markets where prices fall)
    • Incentive: when prices for a good/service rise, it incentivises producers to reallocate resources from a less profitable market to this market in order to maximise their profits. Falling prices incentivise reallocation of resources to new markets
  • Adam Smith referred to the functions of the price mechanism as the 'mystery of the invisible hand'

Price Mechanism at Work in Different Markets

  • The price mechanism operates in all markets including localnational and global

Price Mechanism in a Local Market

  • Long Island, USA has a rich history of agriculture and many producers set up farm shops selling directly to the public. In recent years, honey consumption has increased


A diagram showing the increase in demand for honey in a local market, Long Island


  • Due to a change in one of the conditions of demand (most likely change in tastes), the demand for honey in the local market has increased from D1→D2 and the price has increased from $15 to $18
    • The higher price serves to ration a valuable product. Those consumers who can afford to purchase it at $18, receive it
    • The higher price incentivises producers to allocate more factors of production to producing honey and this is evident from the extension in supply from Q1 to Q2
    • The shift in demand signals to other producers that demand for honey is strong and they should consider entering the market

Exam Tip

It can get confusing explaining some of the differences between the three functions. Thinking about it in the following way helps to simplify the process. If there is shift in demand/supply the market is sending a signal to consumers and producers. If there is a movement along one of the curves, this is as a result of the incentive function.

Price Mechanism in a National Market

  • The T-Shirt market in the UK is highly competitive. In 2018 the price of cotton fell


A diagram showing an increase in the supply of T-shirts in the UK market


  • Due to a change in one of the conditions of supply (a decrease in costs of production), the supply of T-shirts in the UK has increased from S1→S2 and the price has fallen from P1 to P2
    • The lower price increases the number of consumers who can access this product. It is rationed more widely as there is an excess in supply
    • The lower price incentivises consumers to purchase more T-shirts and this is evident from the increase in demand from Q1 to Q2
    • The shift in supply signals to other producers that there is excess supply and they should consider leaving the market

Price Mechanism in a Global Market

  • Cash crops such as wheat, oats, barley, soy, corn, sunflowers etc. can be grown using the same factors of production
    • Many countries export excess crops into the world market
    • Producers use world prices to guide their production decisions


A diagram showing the price mechanism at work in two related global markets, corn and potatoes


  • Farmers in France have been producing corn for many years and the market price is $2/kg. The price of potatoes in global markets has until recently been steady at $2/kg
  • Due to a change in one of the conditions of demand (possibly an increase in global population), the demand for potatoes has increased from D1→D2 and the price has increased from $2/kg to $3/kg
    • The higher price serves to ration the potatoes. Those consumers who can afford to purchase it for $3, receive it
    • The higher price incentivises producers to allocate more factors of production to producing potatoes and this is evident from the extension in supply from Q1 to Q2
    • The shift in global demand signals to producers in France that demand for potatoes is strong and they should consider switching some of their production from corn to potatoes


Exam Tip

Whenever you are faced with questions on the functions of the price mechanism, remember that all three functions are built on the principle of self-interest. This will help you to explain each function.

For example, lower prices incentivises consumers to purchase more of the product with the same income. Conversely, the incentive for producers is the opposite encouraging them to reallocate their factors of production to producing more profitable products.

Each party acts in their self interest