PRICE MECHANISM IN A FREE OR CAPITAL ECONOMY
The price mechanism works through supply and demand of goods and services in competitive markets. In turn, prices are determined. Prices determine the production of innumerable goods and services. They organise production and help in the distribution of goods and services, ration out the supply of goods and provide for economic growth. It works as undero.
1. What and How Much to Produce.
The main function of prices is to resolve the problems of what to produce and in what quantities. This involves allocation of scarce resources in relation to the composition of total output in the economy. As resources are scarce, the society has to decide about the goods to be produced: wheat, cloth, roads, television, power, buildings, and so on. Once the nature of goods to be produced is decided, then their quantities are to be decided. How many kilos of wheat, how many million metres of cloth, how many kilometres of roads, how many televisions, how many million kw of power, etc. Thus, the problem of the nature of goods and their quantities has to be decided on the basis of priorities or preferences of the society. If society gives priority to the production of more consumer goods now, it will have less in the future. A higher priority on capital goods implies less consumer goods now and more in the future.
This fact can be explained with the help of the production possibility curve. Let us suppose the economy produces capital goods and consumer goods. In deciding the total output of the economy, the society has to choose that combination of capital and consumer goods which is in keeping with its resources. It cannot choose the combination R which is inside the production possibility curve PP1 because it reflects economic inefficiency of the system in the form of unemployment of resources. Nor can it choose the combination K which is outside the current production possibilities of the society ; the society lacks the resources to produce this combination of capital and consumer goods, therefore, to choose among the combinations B, provides a guest level of satisfaction. If the society decides to have more capital goods, it Will choose combination B; and if it wants more consumer goods, it will choose combination D
Thus, selection depends on the following factors
(i) Consumers have to pick and choose from the vast variety of goods offered to them. The urgency of desire for certain goods means that the consumers are prepared to pay a large sum of money and higher prices. It implies larger profits for producers producing these commodities. If consumers desire goods less urgently, it means their reluctances to spend more on them and they offer lower prices. Expecting a decline in profits, producers also bring smaller quantities of their products in the market.
(ii) When producers increase the supply of commodity without any regard to the wishes
of the consumers, it will have a low value in their estimation and the lower will be its price. A small supply, on the other hand, increases the prestige of the commodity in the minds of consumers and they pay a higher price for it. Thus, the different prices which consumers pay for various commodities and services reflect their comparative values to them.
(iii) Prices also change with consumer’s tastes and preferences. Consumers register their preferences towards commodities by paying more for them and their distaste by offering less. If consumers show preference for auto-rickshaws and taxis in place of cycle- rickshaws and tongas, they offer lower prices for the latter. Some of the persons engaged in the latter trades will suck other occupations or may even start driving auto-rickshaws and taxis. Therefore, consumers’ tastes and preferences are also reflected in the prices of goods and services.
(iv) A change in the price of a commodity acts as a beacon light and a warning signal to the producer and the consumer. If the price of a commodity rises, it warns the consumers to buy less of it and at the same time it encourages the producer to produce more of it. High prices and prospects of larger profits attract new producers into the industry in the long run. Resource owners also shift their resources to this high priced industry Thus when all firms in the industry produce more, supply increases more than the demand and the price may tend to fall. On the contrary, the withdrawal of resources from the low-priced commodity brings a fall in its output. But the shifting of consumer- demand towards it, tends to raise its price in the long-run. This tendency continues till both the commodities are equally priced and offer the same profits to producers in the two industries.
(v) If the price of a commodity falls, it is a warning to the producers and consumers. Low price and low profits will induce producers to shift resources away from this industry to the high-priced industry. This long-run tendency will reduce supply and the demand will increase. As a result, prices tend to rise. On the other hand, supply increases in the high-priced industry as a result of shifting of resources into it. Demand being less, price tends to fall.
(vi) As the consumer is the sovereign, he sets the price and producers manufacture those commodities which he wants more. The more the producers produce, the larger the profits they carn and so do the resource owners. The fate of the producer is sealed if the consumer has no liking for his product and sets a low price. The producer, thus, reacts when the consumer acts and resource allocation takes place along with the production of goods.
2. How to Produce.
The next task of prices is to determine the techniques to be used for the production of articles. Prices of factor services are the rewards received by them. Wage is the price for the service of labour, rent is the price for the service of land, interest for the service of capital and profit for the service of entrepreneurs. Thus wages, rent, interest and profit are the prices paid by the cntrepre Europe for the services of the factors of production which make up the costs of production.
Every producer aims at using the most efficient productive process. An economically efficient production process is one which produces goods with the minimum of costs. Thus, the choice of a production process will depend upon the relative prices of the factor services and the quantity of goods to be produced.
A producer uses expensive factor services in smaller quantities relative to cheap resources. In order to reduce costs of production he substitutes cheaper resources for the dearer. If capital is relatively cheaper than labour, the producer will use capital-intensive production techniques. If labour is relatively cheaper than capital, labour-intensive production processes will be used. In less developed countries where labour is cheap, techniques involving more labour contribute to least costs; while in developing economies where labour is relatively expensive, a capital using and labour-saving techniques combine efficiency with minimum costs. Since one price for a single commodity prevails in a free enterprise economy, only economically efficient
producers can continue in the industry. Those who are incapable of paying their minimum rewards (prices) will either close down or shift to the manufacture of some other commodity.
3. To Determine Income Distribution.
Another function of prices is to determine the distribution of income. In a free enterprise economy product-distribution and income-distribution are interdependent. It is a system of mutual exchanges where the producers and consumers are largely the same people. The owners of factories call their services for moncy and then spend that money to buy the goods produced by Tractor services. Producers sell goods and services to consumers for money and consumers receive income as owners of factor services. Thus income flows from owners of resources (consumers) to producers and back to consumers again.
Prices play an important role in this income flow. When the consumers buy commodities it is their cost of living. When producers sell commodities, it is their business receipts. What consumers receive as owners of factor-services, it is their personal income and when producers pay for factor-services, it is the cost of production. It means that the income of an individual depends upon the amount of resources owned by him and the evaluation of his resources in the minds of consumers. People owning large quantities of resources have high incomes and/or
They contribute more to the making of commodities which satisfy the consumers much. People owning small quantities of resources have low incomes and/or they contribute little to the making of commodities which add to consumer satisfaction. Such income differentials are, however, self-correcting. No individual can afford to receive a low income for long. So workers in the low-income category will seck employment in that industry which pays higher wages. The movement of workers from the lower-paying industry to the higher-paying industry results in the reduction of supply of the former industry and increase in the supply of the latter industry. Reduction in supply raises the price of the product, increases the profits of the producer and the incomes of the workers. On the contrary, increase in the supply of the other commodity lowers
its price reduces profits as well as the incomes of the workers. This process will continue till income differentials disappear altogether. In this way, prices not only determine income distribution but also brings its equality
4. To Utilise Resources Fully.
The price mechanism also helps in the full utilisation of the resources of an economy. Full utilisation of resources implies their full employment. This requires an increase in income through large investments, and ultimately to the equality of saving and investment. In a growing economy equality between saving and investment is brought about by reductions in interest rates. When the economy is nearing the level of full employment by an efficient use of resources, income grows at a rapid rate, and so do savings. But investment lags behind which can be raised to the level of savings by interest-free reductions. Thus the rate of interest acts as an equilibrating mechanism. Therefore, monetary and fiscal measures and physical controls are also required to influence the decisions of consumers and producers regarding saving and investment.
5. To Provide an Incentive to Growth.
Lastly, prices are an important factor in providing for economic growth. The impetus for improvement, innovation and development comes through the price mechanism. Higher prices and profits encourage large industrial concerns to spend huge sums on research and experimentation to improve and develop better techniques.
The adaptation of the economic system to change in wants, resources and technologies takes place through prices. if consumers want more of one commodity in preference to the other the price of the former rises. Resources move to that industry. Profits also increase.
Larger profits lead to the adoption of superior technology which lowers costs. Larger pots and low costs attract new producers who provide new capital. All this leads to capital formation. No doubt economic growth depends upon a number of other factors, yet prices play an important role in providing for economic growth with stability. This is explained in figure 4. In this diagram, the economy is stagnant at points inside the production possibility curve PP. For its economic growth, it has to be moved on to point A of the production possibility curve PP whereby the economy produces larger quantities of consumer and capital goods. This is possible through a higher rate of capital formation which consists of replacing existing capital goods with new and more productive ones by adopting morc efficient production techniques or through innovations. More growth leads to the outward shifting of the production possibility curve from PP to PP1. Point C represents this situation where large quantities of both consumer and capital goods are produced in the economy. In this way, economic growth enables the economy to have more of both the goods through higher prices, profits and incomes. Thus the price mechanism, working through supply and demand in a free enterprise economy acts as the principal organising force. It determines what to produce and how much to produce. It determines the rewards of the factor services. It brings about an equitable distribution of income by causing resources to be allocated in the right directions. It works to ration out the existing supplies of goods services, utilises the economy’s resources fully and provides the means for economic growth.
The price mechanism does not operate freely. It acts under certain restraints placed by the government in a free enterprise economy. Moreover, there are the “imperfections of competition which hinders the working of the price mechanism.
Let us identify these factors as below:
1. The government issues directives to producers to manufacture goods of different types and in fixed quantities which are required to meet the social wants.
2. Even the resource owners are not allowed to act freely. If the government wants the private sector to produce more for the future, then resources will be reallocated towards or the capital goods sector. People may also be asked to save more and consume less in the present.
3. The imposition of administrative controls, regulating the supplies of goods, rationing
of commodities, issuing of licences, fixation of quotas, etc. are some of the methods which tend to modify the working of an automatic price system.
4. When the government fixes prices of goods and services of say sugar, cloth, steel, etc., and wages of workers, these act as constraints on the working of the free market mechanism.
5. Such measures as progressive income and wealth taxes, provision for social security, price support programme, giving of subsidies, credit facilities, etc., also interfere with the working of the price system.
6. Measures aimed at nationalisation of social services also tend to modify the price
system in favour of a fixed economy.
7. The price mechanism functions under the assumptions of perfect competition. But in the real world, competition is nowhere perfect.
8. The imperfections of competition also lead to the emergence of monopolies which result in wrong pricing, incorrect and wasteful resource allocation and monopoly profits.
9. The price mechanism has increased income inequalities instead of reducing them This is because supply and demand do not work properly. Production is guided by the demand of the flute and not by the needs of the poor. Resources are, therefore, directed towards producing luxury goods for the rich. This further leads to mal-distribution of income.
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