The following article will guide you to learn about how does a market system work.
Let us take a few examples to show how such a system might work. We can start with an increase in demand. Assume that there is an increase in the birth rate in India. Other things being equal, this will mean that producers of products used by babies, such as nappies, cots, push chairs and baby foods, will find that they sell more products.
If production does not rise then shortages will develop. Rational producers and shopkeepers seeking to maximise their incomes will respond to these shortages by putting up prices in order to increase profits. Manufacturers of similar products will note these higher profits and diversify into the market for childcare products. Some shops which sold cycles will now sell push chairs; some which traded in teenage clothes will change to maternity wear.
In this way resources—labour, land and capital—will be re-allocated to produce the goods and services which consumers want. The wishes of consumers will have led to changes which help satisfy these wishes. Indeed, the extra supplies may force down prices so that consumers not only benefit, because they have increased supplies of goods which they want, but also because these may cost less.
Resources are also re-allocated if consumers choose less of a product. If men want fewer hats, ties or suits, the market responds by producing fewer of these commodities. Shops which sell these commodities will have to cut their prices to clear their stocks and either go bankrupt or else diversify into selling clothes that people want.
Producers will similarly be forced to respond to the dictates of market forces. If they continue to produce clothes which consumers are unwilling to buy they will soon go out of business. Their factories and workers will become available to make products which consumers wish to buy.
The system also responds to changes in the supply of goods. For example, if bad weather in Brazil cuts the supply of coffee, this will lead to a shortage. Producers and shopkeepers, being rational, will respond by raising price. In the long-run this may stimulate producers in other countries to increase production. The rise in coffee prices may also encourage some consumers to switch to other drinks such as tea. If tea producers believe that the switch is likely to last long they will increase production.
Thus, the system works to allocate resources whether the impetus for change is a movement in demand or in the supply of goods. Markets are able to function in this way because of the operation of the price system.