Explain the role of “Price mechanism” in assuring proper allocation and full utilization of productive resources in free enterprise economy.
Ans) Price mechanism refers to the process of price determination by the interaction between demand and supply forces without any external interference. That price will come to prevail in the market at which demand for a commodity is equal to its supply. Such a price is called equilibrium price. Operation of price mechanism in a market is explained with the help of the following figure. In this figure, price per unit of the commodity is shown on Y-Axis and quantity demanded and supplied are shown on X-axis.
At OP1 price ,supply (P1B) is more than demand (P1A), ie; there is AB excess supply .In this situation there will be a tendency for the price to fall ,as there will arise competition among the sellers.
On the contrary, at OP2 price, demand (P2G) will be more than supply (P2F) ie; there will be excess demand equal to FG. In this situation, there will be a tendency for the price to rise ,as it will lead to competition among the buyers.
At OP price, demand is equal to supply. Thus, OP price is called equilibrium price. At this price, demand for a commodity is equal to its supply.
Role of price mechanism:
The price mechanism solves the problem of allocation of resources which is associated with what ,how and for whom to produce.
- What to produce?
In a free market economy,producers are guided by profit motive. When price of a commodity increases with the increase in demand ,the profits increase and this would encourage the production of this commodity.Producers would shift resources from the production of other commodities to this commodity.Therefore,the price mechanism would automatically solve the problem what to produce.
- How to produce?
It is the question of choice of production technique .There are generally two techniques of production available:
- Labour-intensive technique (in which more of labour is used than capital)
- Capital-intensive technique (in which more of capital is used than labour)
If capital is available at alower rate, firms adopt capital-intensive technique of production.If labour is available at lower rate,firms adopt labour intensive techniques.
Therefore, it is the price of labour or the price of capital that will help the producer in deciding whether they should choose capital intensive or labour intensive technique.
- For whom to produce?
In a market economy,the producers must produce for those who have the ability and willingness to pay the highest price.The income of the consumers determines the ability to pay ie; there is a direct relationship between income and consumption pattern. Hence,both the ability and willingness to pay determines who gets the available commodities.
- Fuller Utilization of the factors
It is through price-mechanism that fuller utilization of the factors is attained in a capitalist economy .Volume of full employment depends upon the volume of production which in its turn ,depends upon the level of investment. Amount of investment depends upon saving.Equality between saving and investment is brought about by change in price of capital ie; rate of interest.If at any given time ,total savings are large and condition of unemployment prevails in the economy ,the rate of interest will fall.Due to fall in the rate of interest there will be increase in investment.Increase in investment will result into increase in production and the condition of less than fuller utilization of the factors will become possible. Classical economists were of the view that under condition of less than full employment of labour,price of labour, ie; wage will fall. Fall in wage rate will stimulate demand and condition of full employment of labour will be achieved . In this way,price mechanism will help to achieve fuller utilization of the factors.