Role of Price System in Modern Economics

In this article we will discuss about the role of modern economics in modern economics. Also learn about the merits and advantages of price systems.

Economics is the study of how man can provide for his material well-being. Although man does not live by bread alone, it is equally true that he cannot live without it. An underlying problem in all economies is that of survival and we must examine how people have solved or are trying to solve this problem. As such economics analyses the way in which man can apply his skills, efforts and knowledge to the available natural resources in order to produce those goods and services which will satisfy his wants.

This problem of scarcity, forcing us to make choices, is actually the problem of how to allocate existing resources to different users and how to allocate the resulting goods and services to different members of society. Different society may have different approaches to resolving these prob­lems, but the problem remains the same everywhere. The three problems which all societies are forced to solve can be expressed as what, how and for whom?

1. What? Refers to the problem of which goods should be produced and in what quantities.

2. How? Refers to the method of producing the goods, making the best use of available resources.

3. For Whom? Refers to the way in which the total output is to be distrib­uted amongst the members of the community.

In a capitalist economy these three problems are shared by the price system:

1. Output determination:

In the first place, the price system gives the ultimate decision to consumers as to what goods and services will be produced.

Every time a consumer makes a purchase, it is like registering a vote in favour of the continuing production of that article. As retailers find their stocks diminishing, they re-order from the wholesaler or the manufacturer. The latter makes further supplies.

On the other hand, if manufacturers find that orders for certain articles are declining because consumers’ demand is falling; they will make fewer of them.

If consumers’ demand for a particular article increases rapidly, there will be a shortage of supplies in the shops. Scarcity will cause a rise in price. This will have two effects. First, the price increase with ration out the quantity available by reducing the number of buyers; secondly, the prospect of greater profits will encourage producers to increase supplies.

A falling-off in demand by consumers will have the opposite effect. Sellers will reduce their prices in an effort to clear their stock and a fall in price will have two results. First, profits will full and may even become zero or negative; in which case they will stop production. Hence supplies will diminish. Secondly, demand will increase because consumers will be will­ing to buy more at lower prices.

Thus, consumers’ demand, acting through the price system, determines the assortment and quantity of goods produced. It is sometimes said that under a private enterprise system ‘the consumer is the king.’

2. Resource allocation:

The second function of the price system is the distribution of scarce resources among competing producers. Those indus­tries which can offer the highest prices for the factors of production are able to attract supplies. On the other hand, industries which find that factor prices are too high to yield a profit from manufacturing are forced to contract. Thus, productive resources switch to industries whose goods are in more urgent demand.

An example will make the working of the price mechanism clear. If consumers decide that they want more gloves than are currently being manufactured, and fewer shoes, there will be an increased demand for the stock of gloves on the market and a slackening of demand for shoes. As a result, glove prices will rise as consumers seek to buy more of them than are available and shoe prices will tend to fall as the public decide against buying more shoes.

When glove prices rise, profits in that industry will rise, too, and as shoe prices fall, profits in that industry will fall. Consequently, workers will be released from the shoe factories as output contracts and will move to the glove business where more workers will be required to produce a greater supply of gloves. The result is that glove production tends to rise and shoe production tends to fall. Through the price mechanism, society has changed the allocation of its productive resources to fit its new desires.

3. Organisation of production:

The third function of the price system is to determine who should produce goods and services and which methods of production should be used.

These matters are decided by competition among different producers. Those who are more efficient because their costs of production are lowest will succeed in supplying a commodity at a lower price than their competi­tors. The inefficient will be forced to go out of business. In a similar way competition determines the methods of production used. The chosen meth­ods of production will be those by which costs are reduced to the minimum.

4. Income distribution:

The price system must also influence the distri­bution of income. People’s earnings depended the price they receive for their services. In the case of employed workers, wages will depend largely on the success of their employers’ businesses and on the demand and supply of people with particular skills. People with skills that are not required by employers receive low earnings. Someone who is good at sweeping the streets will receive low earnings, because there are many people with this ability relative to the demand for them.

The price system determines the way in which the goods and services produced are distributed among members of a society.

The share of goods and services available to people depends on the level of their income. Income is earned either by some form of labour or it is derived from the ownership of property. The amounts of these incomes are determined by the conditions of demand and supply in the markets for land labour and capital. Wages, interest and rent are prices and their levels depend upon two factors, namely, their supply and consumers’ demand for the products they help to make.

If demand for a product is rising, firms engaged in its production will expand, their demand for factors of produc­tion will increase, and the incomes of the factors will rise. Conversely, if consumers’ demand for a product is declining, then the incomes of factors engaged in producing that product will tend to fall.

5. Information transmission:

The price system must transmit informa­tion to the people who need to know. If there is a boom in one sector of the economy, shopkeepers selling these products will increase their orders to the manufacturers and, in order to persuade manufacturers to supply more goods, they will probably have to pay higher prices.

This will induce the suppliers to increase their work force — or make it possible for them to pay overtime rates of pay. All the people involved in this market will be aware of the change in prices. The information will be of no interest to those in different markets and will be ignored by them.

6. Incentives:

The price system must provide incentives to people to act in certain ways. If the price of a product is rising it will pay producers to increase output, because this will cause their profits to rise. If wages in one occupation are rising it will pay some workers to shift jobs. If one shop sells a product at a lower price than its competitors then it will pay consumers to buy at that shop (though there are costs involved in changing jobs and in shopping around, particularly the time involved).

Merits of the Price System:

There are various advantages to be secured from the price system in a market-based economy.

The main advantages are the following:

1. It is an Automatic and Self-Regulating Process:

No elaborate adminis­trative machinery is required to operate the price mechanism and yet, by means of it, goods and services are produced and distributed to where they are most in demand. Adam Smith (who is generally agreed to be the founder of economic science) wrote in his Wealth of Nations (1776) of ‘the invisible hand’ which, acting through each person’s self-interest and the competition resulting there-from, provides those goods that society wants in the quantity that society desires and at the prices which society is prepared to pay.

2. Freedom of Consumer:

It offers freedom of choice to consumers. Consumers express their particular tastes and preferences by the way their incomes are spent. Hence, demand influences prices, and so consumers determine what is to be produced. If a producer does not make what consumers want then his rivals will. Thus, it is the consumer who has the final say under private enterprise.

3. Initiative and Enterprise:

The price system provides conditions in which initiative and enterprise can flourish.

The price system is based on the profit motive. It assumes that personal interest (or as Adam Smith called it ‘the natural effort of every individual to better his own condition’) is the root of all economic activity. When demand exceeds supply and prices rise, producers are encouraged by the prospect of making profits to increase supply. In a system where enterprise is rewarded in this way, people will be alert to opportunities of meeting new or increasing demands for goods and services.

Demerits of the Price System:

The price system is open to criticisms on a number of grounds:

1. Production of Wrong Commodities:

A system based on self-interest and the profit motive supplies only those needs which can find expression in terms of money. Goods go to those who are prepared to pay the highest prices. Consequently, the rich may enjoy luxuries while the poor lack necessities Thus, a person with no money and without food has a desperate need, but in a market economy his strong desire for food does not get reflected in a high demand for food.

2. Loss of Community Interest:

The price system does not recognise any sense of duty to the community. Only those goods and services offering a profit are produced and so it is doubtful whether vital services such as the judiciary, a universal system of education and the various social amenities such as libraries, parks and gardens would be made available.

3. Waste of Resources:

The system may lead to some waste of economic resources. The transfer of resources from declining industries to those which are prospering may take a very long time. Labour and capital may be unemployed for years and consequently resources may remain unused.

4. Monopolistic Imperfection:

Competition is an essential requirement for the working of the price system and it may break down because of the development of monopoly situations. Generally, the latter are harmful to society.

For example, an employer may be the sole buyer of labour in a particular region and lack of competition provides him with an unfair bargaining power in fixing wage rates. Similarly, if a producer is the only supplier of a particular product, then consumers are forced to pay the price asked for or go without it. They cannot purchase it elsewhere.

5. Social Cost (Externality):

The exercise of the freedom to obtain the most advantageous return from resources may result in actions which are detri­mental to the welfare of the community.

For example, a builder may erect houses cheaply in order to maximise profits and without regard for the safety of people who will live in them; a manufacturer may allow unpleasant fumes to pollute the district surround­ing a factory rather than incur expenditure in preventing the nuisance. In a similar fashion if it is cheaper to use child labour than adult workers, then child workers will be employed without consideration of the effects on the health of the next generation.