Prices are profits are used as signs in the economy to consumers and firms – this process is known as the price mechanism. Decisions made by consumers and firms are based upon the prices and profits available in a particular market. Prices and profits have three main functions in an economy:
- Rationing – we know that resources are scarce, but consumer wants are infinite. Prices are used to help determine how these scarce resources will be allocated between competing uses, in other words prices are used to ration resources. Supply will be rationed to those who are willing to pay the price for it. The increase in price acts as a way of further rationing demand and a fall in the price will lead to an end in the rationing as more consumers are able to purchase it.
- Signalling – the price of a good is a vital piece of information to both buyers and sellers. The price reflects market conditions and will therefore act as a signal, communicating information to those in the market. Decisions about buying and selling are based on those signals.
- Incentive – the price acts as an incentive for the consumers and firms in the market. Low prices are incentive for buyers to purchase more goods. Rising prices will also increase the incentives for firms supplying the market.