In this article we will discuss about the mechanism of price system. Also learn about its functions and purposes.

All economies face the same problems although their approach to solving them may differ.

In a capitalist country, or even in a mixed economy like our own, prices perform, or can be used to perform, three basic func­tions:

1. The allocation of the factors of production to specific uses.


2. The distribution of the total output or the national income, and,

3. The rationing of customer goods.

The extent to which prices perform these functions satis­factorily depends upon the way prices are determined.

Functions of Prices in a Free Enterprise (Market-based) Economy:


Where free enterprise exists, free market prices are relied upon to indicate the demand for goods and services of different kinds. A rise in the price of mutton is interpreted by sheep growers to mean that more cattle is wanted by consumers. A fall in the price of mutton is likewise noticed when demand is less than supply, and that, if prices are to be restored, there must be either a decrease in the number of sheep’s offered on the market or an increase in demand for mutton.

In the absence of price fixing by the government or central planning authority, price is the result of the relationship between the demand for and the supply of a commodity. For example, in most cases if the demand for a good remains constant while supply diminishes, its price will rise. If its demand diminishes while its supply remains constant, price will fall.

On the other hand, as a rule, if demand and supply increase or decrease proportionally, its price will not be affected. Other possible combinations in the relationships between demand and supply tend to produce certain definite changes in the price of the good. The prices resulting from demand and supply relationships are assumed to be determined automatically so long as producers and consumers are free to act according to their own inclinations.

In a free enterprise economy indications of a need for more or for less goods of a particular kind are made known by prices that are not fixed by personal or by governmental edict. Under such a system, consumers are assumed to know what goods they want, how much they want, and what price they are willing to pay.


Profit seeking producers are depended upon to provide the quantity and quality of goods that are wanted. Existing or potential entrepreneurs are assumed to be ready and willing to provide the goods desired, as long as the price is such that there is an opportunity for making a profit.

The reliability of prices as a guide to production depends upon the extent to which competition prevails. Where monopoly exists, high prices cannot always be relied on to bring about an increase in production.

1. Prices and the Allocation of the Factors of Production:

When the desire for making profits is assumed to be the incentive for production in the economy, prices are depended upon to allocate the factors of production to various kinds of industry and business. Other things being equal, enterprisers undertake to utilise land, labour and capital for the production of those goods that seem to promise the maximum amount of profit.

The process by which the factors of production are directed to the production of different goods according to profit prospects is not very simple. Generally, before undertaking the production of a good, the entre­preneur estimates the number of units that he can sell at each of several given prices. Then he estimates the cost of producing these quantities.

If he decides that the undertaking would be worth the risk — that he could probably make a satisfactory profit — he sets about gathering the propor­tional amount of labour, capital and materials needed for producing an approximate number of units. The amount of labour, capital and natural resources he will employ in production will depend, in part, upon the price he has to pay for the units of each factor.

Obviously, then price is the determining factor in decisions affecting the utilisation of scarce resources or factors of production. In the first place estimates as to possible revenue can be arrived at only by a consideration of expected selling prices of finished goods. The volume of demand for each of the factors of production will, in turn, depend upon the price of each factor in relation to its value in producing the good.

The demand for land, labour and capital derives from the demand for finished goods. The prices of finished goods depend, at least in part, upon the utility and the scarcity of the goods. The scarcity of finished goods however, may be conditioned largely by the scarcity of the factors of production.

The demand as reflected in terms of price tends to direct the relatively scarce land, labour and capital to the production of those goods the price of which will enable producers to pay the highest prices for the factors of production.


Whether the goods that are produced are those that are socially most worthwhile is another matter. Under a system of free enterprise, however it is assumed that the needs of society for goods and services of various kinds and quantities are indicated by prices. For example, it is taken for granted that a rise in the price of bread will cause more land, labour and capital to be devoted to the production of wheat and bread; but price is not an infallible guide to the production of those goods that are the most socially necessary or desirable for the general welfare of society.

Although the composition of production is determined by a democratic process based upon prices and votes as expressed by consumers, the situation can lead to inequities since those with the most rupees have the most votes.

If for some reason certain individuals or groups acquire an excessive number of rupees and others have an extreme scarcity of rupees, it could operate to the detriment of the total economy. In fact, we might face a situation in which an economy might produce a huge quality supply of luxury apartment’s swimming pools and high-priced cars while having an insufficient amount of bread, medical care or low-cost housing essential for the best interest of the total economy.

To abandon prices as a method of directing production, however re­quires the substitution of political controls, such as those existing in the Chinese economy. Except in times of emergency or in the production of certain goods, such as school buildings or highways, the people in a capi­talist country like the U.S.A. or the U.K. have preferred to rely as much as possible on free market prices rather than politics to decide what use shall be made of the factors of production.


In a typical capitalist economy when the powers of the government have been invoked to influence production it has generally been in an indirect fashion, such as making more credit available for the construction and purchase of homes, favouring domestic producers with an import tariff, paying subsidies to farmers and granting financial aid to the needy and the aged.

2. Prices and the Distribution of the National Income:

By the system of prices and votes, societies not only determine what is going to be produced, but they also determine, at least in part, the remuneration that is to be received by the various factors of production.

Since the revenue from the sale of goods and services is the means by which the business people acquire the necessary factors of production to produce the goods and services the consumers desire, the more consumers are willing to pay for these goods and services, the greater the means at the disposal of the producer to obtain the necessary factors of production.


Although many other things, such as the productivity of labour, the stage of technological development, the supply of resources, and the presence of labour unions have a direct bearing on the payment to the factors of production, revenue from consumer demand is the ultimate source of income payments.

The present strong demand for homes and air service, for example, is in large part the reason why pilots and building promoters are among the higher income- earners in India at present. Our desire for entertainment affords large-scale remuneration for TV stars. High demand for office space in a central location provides high rental income to the landlord.

The income received by the owners of these and other factors of production in the form of wages, rent, interest arid profits, of course, provides the purchasing power needed to obtain a certain share of the total goods and services produced by the nation’s economy. Thus, the price (market) system gener­ally serves to distribute national income and to divide the total output of goods and services among the owners of the factors of production according to their respective economic contributions as measured by the consumer demand.

3. Prices and the Rationing of Goods:

The possibility of getting goods and services of any kind usually depends upon the amount of money individuals have to spend and the prices of the goods they wish to buy. When the money income of the majority of the people is high in proportion to the prices of goods, the people can afford to buy a wide range of commodities and in sufficient quantities.

On the other hand, in any economy, when money incomes are small in proportion to the prices of goods, only a fortunate few are able to obtain more than the simple necessities of life. Since the total desire for goods and services is generally greater than the capacity of the economy to produce, the system of consumer demand and prices serves as a rationing mechanism to decide who will get what of the available goods and services.


As prices rise, those with the higher incomes and the willingness to pay will be able to obtain particular goods and services, while others who do not have the income or are unwilling to pay the high prices must go without them.

With a given -amount of money to spend, one may select those articles that he can afford according to their respective utilities to him. In this way he gives maximum priority to those wants which appear to be the most urgent and pressing. By a process of attempting to equalise all of his wants he is able to derive the greatest total amount of satisfaction from the use of his money.

A Picture of Prices and Markets:

How the price system solves society’s economic problems is illustrated in Fig.1.

The Choice between Military and Civilian Goods

Fig. 5 provides an overview of how consumers and producers interact to determine prices and quantities of both commodities (goods and services) and factors of production. In this circular flow diagram we show the operation of two types of markets, the commodity market (or the market for output) and the factor market (or the market for inputs).


In the upper part of the diagram we show the product market, or the market for various goods and services such as bread, butter, oranges, shoes, etc. In the lower part of the diagram we show the markets for factors of production like land, labour and capital. In both the markets two types of decision—purchase decisions and sales decisions—are made by two basic units of the economy viz., households (the consuming unit) and business firms (the producing unit).

A Picture of Prices and Markets

Households buy goods in the commodity market and sell factors of production; business firms sell goods and buy factors of production. House­holds use their income from sale of labour and other inputs to purchase goods produced and supplied by business firms; business firms set (fix) their prices of goods on the basis of costs of factors (such as rent of land wages of labour and interest on capital).

Prices set in commodity markets balance consumer demand with business supply. Likewise, prices in factor markets are set to balance household supply with business demand.

Fig.1 simply gives a total picture of how the interdependent supplies and demands interconnect through a market mechanism to solve the economic problems of society, viz., what, how and for whom. A close look reveals that rupee votes of households interact with what businesses supply in the goods markets at top half of the diagram, helping to determine what is produced.

Furthermore, business demand for factors of production (inputs) meets the public’s supply of labour and other factor inputs such as land labour, capital and entrepreneurial talent in the factor market in the bottom half of the diagram, to determine factor prices, viz., rent, wages, interest as also profits (and dividends).


Factor prices and income distribution are interrelated. And output dis­tribution (or distribution of GNP) depends on income distribution. Those with high incomes are able to buy more of society’s output than those with low incomes.

The price of a factor, together with the quantity of the factor will determine the income of (return to) the factor. If the demand for labour is high the wage rate will also be high and workers will be enjoying a high standard of living.

The problem of ‘for whom’, the problem of distribution is determined by relative incomes which, in turn, are determined by supply and demand in the markets for productive services. If labour is scarce relative to its demand then wages will be higher and a greater proportion of output will go to wage earners; the same is true of owners of land and capital.

Competition among business firms to buy factor inputs as cheaply as possible to produce or sell goods determines how goods are produced. The technical problem of ‘how to produce’ is determined by competition between producers which forces each to adopt the least cost method of production (i.e., the method of presentation which minimises cost per unit).

In a market economy resources are allocated by the operation of market forces of demand and supply, working through the price system. In this system no individual or organisation consciously seeks to solve the basic economic problems of what to produce, how to produce, or for whom should production be organised.

In other words, all the participants in the system — workers, employers — consumers-try to maximise their own utility. Consumers will try to buy goods and services as cheaply as they can. Producers will try to charge high prices and pay low wages so that they maximise their profits. Workers will aim to obtain high wages.


Prima facie, changes in consumer demand will also affect wages. Workers in industries, where there is a rising demand for the products that they make will be able to benefit by negotiating higher wages.

Those in declining industries will find that their wages fall relative to those in other sectors of the economy. Some workers will respond to this by changing jobs. In this way consumer preferences for particular products will encourage labour to be re-allocated, so that workers are available to produce the goods that people want.