The price mechanism

In solving the 3 basic problems of an economy

Meaning

• A system where price acts as automatic signals which coordinate the actions of individual decision making units

• Applicable in capitalist economies

Types

• Price mechanism under free market economy

• Price mechanism under controlled or command economy

Difference

• Adjustment in prices through demand supply interaction

• Relevant for capitalist economy

• Solves economic problems through market forces

• Administered price mechanism to achieve pre specified economic targets

• Relevant for socialistic economy

• Solves economic problems through planning with positive government intervention

FUNCTIONS OF PRICE MECHANISM

• The level of economic activities

• Co-ordination of economic decisions

• Guiding force to consumers and producers

• Determination of factor income

• Allocation of resources

• Determination of savings

• Flexibility of the economy

Solutions to the basic problemsWhat to produce?

1. Commodities with positive prices

2. More of Commodities with relatively higher prices

How to produce?

1. Production technique chosen according to factor prices

2. Employing factors which are relatively abundant and also cheaper

For whom to produce?

1. Depends on purchasing power

2. Factor income

Conditions for free price mechanism

• Output exceeds self consumption• Technology developed enough• Facilities of exchange• Existence of competition• Mobility of resources• Demand reflecting need and cost reflecting

sacrifice• Non economic conditions

Evaluation: advantages

• No intervention: self enforcing

• Preservation of individual freedom

• Promotes social welfare

• Solves economic problems

Evaluation: limitations

• Creation of monopoly

• Inequality in the standard of living

• Problem of economic development

• Problem of business cycle

• Production of public utilities neglected

Role of government

• Prices are administered

• Decisions of production , consumption and distribution are controlled

• Allocation of factors and their income decisions are controlled

• Direct and indirect role of government in solving economic problems

Which mechanism is suitable for a mixed economy

?