The price mechanism has four main functions: 1) Allocation of scarce resources through prices that signal relative scarcity. 2) Rationing of scarce resources when demand exceeds supply through higher prices deterring some consumers. 3) Signalling changes in market conditions through price adjustments that inform producers and consumers. 4) Incentivizing consumers and suppliers by changing incentives in response to price changes. In an economy like the UK, prices resolve issues of trade-offs and opportunity costs. The rationing and signalling functions are then discussed in more detail with examples.

2. Main Functions of the Price Mechanism
1. Allocate – allocating scarce
resources among competing uses
2. Rationing – prices serve to ration
scarce resources when market
demand outstrips supply
3. Signalling – prices adjust to
demonstrate where resources are
required, and where they are not
4. Incentives – e.g. when the price of
a product rises, quantity supplied
increases as businesses respond!
Prices send
important signals
Prices change incentives
for consumers and
suppliers
In an economy like the UK, many decisions on how to resolve the
issues of opportunity cost and trade-offs are resolved by prices.

3. The Rationing Function
The rationing function - when there is a shortage of a product, price
will rise and deter some consumers from buying the product
Higher food prices Rising cost of renting
Online auctions Tickets for major event
D1
P1
Price
Quantity
S1S2
P2 In recent years the
rise in food prices
plus declining real
incomes has
highlighted the
rationing function
of the price
mechanism

4. The Signalling Function
The signalling function - changes in price provides information to
both producers and consumers about changes in market conditions
Coffee farmers Shale oil and gas
Share prices send signals Interest rates on loans
“Cotton farmers hit hard as prices drop to
lowest since 2009” (December 2014)
Plentiful global supplies of cotton thanks to
favourable weather have caused cotton prices
to fall to a 5 year low. China’s farmers
benefited from a $5bn scheme which ran from
2011-14 where the government purchased
cotton at a minimum price, building up a huge
stockpile — China’s reserves have risen six-fold
since 2010 and it holds 60% of the world’s
cotton inventories. The slump in prices is being
badly felt by growers in the southern African
country Zambia whose cotton industry
employs a fifth of the population.
Consider the price signals in this example

5. Real World: Explaining Changes in UK Footwear Prices
80
85
90
95
100
105
110
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
ConsumerpriceindexforfootwearproductsinUK
Global competition
from lower cost
countries
Intense retail
competition on the
high street and online
Falling input costs
have increased market
supply
Strong exchange rate –
which makes imports
of shoes cheaper