Price mechanism: what it is

The price mechanism is the way prices change to allocate scarce resources through the interaction of demand and supply in a free market.

At its core, it answers two exam questions: who gets the good (consumers), and who produces more or less (firms).

The three functions you must apply

Rationing function

When a product becomes relatively scarce, the price rises and some consumers are priced out (rationing consumer demand) , this reduces quantity demanded until the shortage falls. If there is a surplus, the price falls, making the good more affordable, so quantity demanded rises.

Incentive function

A higher price increases potential profit, incentivising firms to increase quantity supplied (a movement along the supply curve). A lower price reduces profit, so firms cut output (a movement back along the supply curve).

Main assumption (great eval) : All firms are profit maximisers 

Signalling function

A rising price signals a market is more profitable, encouraging entry or a shift of resources into that market. A falling price signals lower profitability, encouraging exit or switching resources elsewhere.

You can link this to Adam Smith’s idea of the “invisible hand”, where self-interest helps coordinate resource allocation.

How the price mechanism removes a shortage

In the diagram, equilibrium occurs at Pe and Qe, where demand equals supply. The market initially operates at a lower price, P1, which is below the equilibrium price.

Excess demand at P1

At the price P1, quantity demanded is greater than quantity supplied. Quantity demanded is Q2, while quantity supplied is Q1.

Because Q2 > Q1, there is excess demand, also known as a shortage, in the market.

How the price mechanism works

To remove excess demand, the price mechanism operates through three key functions. These functions cause price to rise and move the market back towards equilibrium.

Rationing function

The shortage leads to competition among consumers for the limited goods available. Firms respond by raising prices from P1 towards Pe.

As price rises, quantity demanded contracts as some consumers are priced out or switch to substitutes. This is shown as a movement up along the demand curve from Q2 towards Qe.

Incentive function

Higher prices increase potential profits for firms. This incentivises producers to increase output.

As price rises, quantity supplied increases, leading to an extension of supply. On the diagram, this is shown as a movement up along the supply curve from Q1 towards Qe.

Signalling function

The rising price sends information to both consumers and producers. It signals firms to produce more or enter the market, while signalling consumers to reduce consumption.

This strengthens the contraction in demand and the extension in supply, helping eliminate the shortage.

Final outcome

As price rises from P1 to Pe, quantity demanded falls from Q2 to Qe and quantity supplied rises from Q1 to Qe. Excess demand is removed from the market.

The market returns to equilibrium at Pe and Qe, where demand equals supply.

How the price mechanism removes a surplus

In the diagram, equilibrium is at Pe and Qe, where demand equals supply. The market initially operates at a higher price, P1, which is above the equilibrium price.

Excess supply at P1

At the price P1, quantity supplied is greater than quantity demanded. Quantity supplied is Q2, while quantity demanded is Q1.

Because Q2 > Q1, there is excess supply, also known as a surplus, in the market.

How the price mechanism works

To remove excess supply, the price mechanism causes price to fall. This happens through the same three functions, but they operate in reverse.

Rationing function

With excess supply, firms struggle to sell all their output. To attract consumers, firms lower prices from P1 towards Pe.

As price falls, quantity demanded increases. This is shown as an extension along the demand curve from Q1 towards Qe.

Incentive function

The fall in price reduces profit margins for firms. As production becomes less profitable, firms cut back on output.

This causes a contraction of supply, shown as a movement down along the supply curve from Q2 towards Qe.

Signalling function

Falling prices send information to the market. Firms are signalled to reduce output or leave the market, while consumers are signalled that goods are cheaper.

This reinforces the extension of demand and the contraction of supply, helping eliminate the surplus.

Final outcome

As price falls from P1 to Pe, quantity demanded rises from Q1 to Qe and quantity supplied falls from Q2 to Qe. Excess supply is removed from the market.

The market returns to equilibrium at Pe and Qe, where demand equals supply.

Using the price mechanism after a shift in demand 

The market initially starts in equilibrium, where the original demand curve D intersects supply S at equilibrium price Pe and equilibrium quantity Qe.

Demand then increases from D to D₁, for example due to a rise in incomes or a change in tastes. At the original price Pe, quantity demanded rises to Q2, while quantity supplied remains at Qe, creating excess demand (a shortage).

This excess demand puts upward pressure on price, causing the price to rise from Pe to P1.

As price rises, the rationing function occurs. Some consumers are priced out of the market, leading to a contraction in quantity demanded along D₁, from Q2 to Q1.

At the same time, the higher price increases potential profit. This triggers the incentive function, encouraging firms to increase quantity supplied, shown by an extension along the supply curve from Qe to Q1.

The rise in price also performs a signalling function, indicating that demand is strong and the market is more profitable, encouraging firms to allocate more resources toward production.

These effects continue until a new equilibrium is reached at price P1 and quantity Q1, where quantity demanded equals quantity supplied.

Price mechanism in different contexts

Local markets

In local markets, changes in tastes can increase demand and push up prices. Higher prices ration the good and signal local producers to increase supply.

A UK example is local housing markets. In cities like Manchester or Bristol, rising demand from students and workers has pushed up rents. Higher rents ration housing and incentivise landlords and developers to provide more rental properties.

National markets

National markets often respond to changes in production costs. A fall in costs increases supply, leading to lower prices and higher quantity demanded.

A UK example is petrol prices. When global oil prices fall, petrol becomes cheaper at the pump. Lower prices encourage drivers to consume more fuel and signal suppliers to increase distribution.

Global markets

In global markets, world prices guide production decisions through signalling and incentives. Producers switch resources toward goods with higher world prices.

For example UK farming. When global wheat prices rise relative to other crops, UK farmers are incentivised to allocate more land to wheat production, responding to higher expected profits.