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Introduction to Business Economics

Role of Price Mechanism

In economics, every country faces some basic problems of an economy. These are problems in relation to what and how to produce goods? Or the provisions to be made for economic growth. Price Mechanism is a key tool in solving all these problems, immaterial of the type of economy. Let us take a look.

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Role of Price Mechanism in a Capitalist Economy

In a capitalist economy, the prices of all goods and services will be decided by the market forces exclusively, i.e. the demand and supply of goods. In such a scenario price mechanism plays an important role. It helps us answer the following questions about the economy,

  1. What to Produce: This is the first function of prices, it will help us decide what to produce. Resources in any economy are limited or scarce, so they must be allocated according to in relation to the total output. Hence prime mechanism will help dictate what goods to be produced.
  2. How much to produce: The next question that needs answering is the quantity of production required. The resources are limited so the quantity will depend on the preferences and requirements of the society and the relative prices of the product.
  3. How to Produce: Then the decision must be taken about the method of production. Say for example you are producing cotton textiles. Should you employ a labour-intensive method or an automated method? This will depend on the availability and prices of the factors of production (labour, capital etc.)
  4. For whom to Produce: An economy cannot satisfy the needs and wants of every person. So the price mechanism will decide how to distribute the total output among its citizens.
  5. Provisions for Economic Growth: An economy cannot use up all of its limited resources. It has to make provisions for the future so the economy can grow. Otherwise, the economy, income levels, output etc will stagnate and may even decline. So the level of savings and investment must be decided.

Role of Price Mechanism in Capitalist, Socialist and Mixed Economy

Role of Price Mechanism in Socialist Economy

In a socialist economy, the decisions of what, how and for whom to produce is not dependent on market forces or price mechanism, these decisions are taken by the Central Planning Authority.

So while the price mechanism does play a role in a socialist economy, it is a very minimal role. It is used to ensure the disposal of stock that has accumulated in the economy.

Since the allocation of resources is planned by the authorities, the price mechanism will have no say here. And there is no profit motive in socialism, so again price mechanism has no role in the area.

Role of Price Mechanism in Mixed Economy

Here price mechanism will pay an equal role along with the planning authority. Especially in the private sector of such an economy, the price mechanism along with the competing forces helps the economy with an allocation of resources and other such efficient decisions.

The decision of what to produce in the private sector will depend on market forces, but in the public sector that decision will fall on the central planning authority. Prices will be fixed by the authority on profit-price policy or no-profit no-loss policy. How to produce goods will also depend both on price mechanism and government interaction.

Solved Question on Price Mechanism

Q: A capitalist tool uses price mechanism, a socialist economy uses central planning and a mixed economy uses ____ to solve its basic economic problems.

  1. Price Mechanism
  2. Central Planning Authority
  3. Both of the above
  4. None of the above

Ans: The correct option is C. In a mixed economy, both market forces and government intervention will be responsible for answering and solving the basic questions of an economy.

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