Price Mechanisms and Resource Allocation

This lesson draws together the themes of the course by examining how the price mechanism allocates scarce resources in a market economy. You will study the rationing, signalling, and incentive functions of prices in detail, explore the ideas of Adam Smith and Friedrich Hayek on the role of markets, and evaluate the strengths and limitations of the price mechanism. This is a fundamental topic for AQA A-Level Economics and provides the basis for understanding market failure (Paper 1, Section B).

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What is the Price Mechanism?

Key Definition: The price mechanism is the system by which the forces of demand and supply determine prices in a market, and prices in turn allocate scarce resources among competing uses.

In a free-market economy, no central authority decides what to produce, how to produce it, or for whom. Instead, the decisions of millions of individual consumers and producers are coordinated through the price mechanism. Prices emerge from the interaction of demand and supply, and they serve as the signals and incentives that guide resource allocation.

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The Three Functions of the Price Mechanism

1. The Rationing Function