The Market Mechanism

Imagine you have a new idea for a product. How do you know if people want to buy it? How much would you supply to the market and at what price? Fortunately, you don't have to worry about any of this! All this is done through the market mechanism and its functions.  In this explanation, you will learn how the market mechanism works, its functions, and its advantages and disadvantages.

The Market Mechanism The Market Mechanism

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Table of contents

    What is the market mechanism?

    The market mechanism links the actions of the three economic agents: consumers, producers, and owners of the factors of production.

    The market mechanism is also called the free market system. It is the situation where decisions on price and quantity in a market are made based on demand and supply alone. We also refer to this as the price mechanism.

    The functions of the market mechanism

    The functions of the market mechanism spring into action when there is a disequilibrium in the market.

    Disequilibrium in the market occurs when the market fails to find its equilibrium point.

    Disequilibrium in the market happens when demand is greater than supply (excess demand) or supply is greater than demand (excess supply).

    The market mechanism has three functions: the signalling, incentive, and rationing functions.

    The signalling function

    The signalling function relates to the price.

    The signalling function is when a change in price provides information to consumers and producers.

    When prices are high, this would signal to producers to produce more and would also signal a need for new producers to enter the market.

    On the other hand, if prices fell, this would signal consumers to buy more.

    The incentives function

    The incentive function applies to producers.

    The incentive function happens when a change in prices encourages firms to provide more goods or services.

    In colder periods, the demand for warmer clothes such as winter jackets increases. Thus, there is an incentive for producers to make and sell winter jackets as there is a greater guarantee that people are willing and able to buy them.

    The rationing function

    The rationing function applies to consumers.

    The rationing function is when a change in price limits consumer demand.

    In recent times, there has been a shortage of fuel in the UK. Due to limited supply, the price for fuel increases, and demand falls. This has limited consumer demand. Instead of driving to work/school, people opt for public transport instead.

    One of the fundamental economic problems is scarcity. Any change in price causes demand to be affected and resources to be rationed amongst the people who are willing and able to pay.

    The market mechanism diagram

    We can graphically show the functions of the market mechanism at work through two diagrams.

    In Figure 2, we assume the prices are low in a particular market.

    market mechanism functions of labour market with low prices studysmarterFigure 2. Functions of labour market with low prices, StudySmarter Original

    As you can see in the figure above, the quantity demanded far exceeds the quantity supplied. The signalling function tells producers to supply more of that particular good or service to the market. Producers also have a profit incentive, so as they supply more, the price in the market starts to increase and they can make more profit. This sends consumers a signal to stop buying the good or service because it's becoming more expensive. The increase in price limits consumer demand and they now leave that particular market.

    Figure 3 illustrates the situation when the quantity supplied far exceeds the quantity demanded. This occurs when prices in a particular market are high.

    market mechanism functions of labour market with high prices studysmarterFigure 3. Functions of labour market with high prices, StudySmarter Original

    As we can see in the figure above, the quantity supplied far exceeds the quantity demanded. Because there is excess supply, producers aren't selling much and this impacts their profits. The signalling function tells producers to reduce the supply of that good or service. The reduction in price signals consumers to buy more and other consumers now enter into this market.

    Allocation of resources and the market mechanism

    What we have essentially been looking at which the help of the two diagrams, is how resources are allocated in a market.

    The relationship between supply and demand plays a very important role in deciding how scarce resources are allocated.

    When there is excess supply, it's not rational for scarce resources to be used for this good or service if there isn't much demand for it. When there is excess demand, it's rational to use scarce resources for this good or service because consumers want and are willing to pay for it.

    Each time there is a disequilibrium, this mechanism allows the market to move to a new equilibrium point. The reallocation of resources that takes place with the market mechanism is done by the invisible hand (without involvement by the government).

    The invisible hand refers to the unobservable market force that helps the demand and supply of goods in the free market reach equilibrium automatically.

    Advantages and disadvantages of the market mechanism

    Like all microeconomics theories, there are both advantages and disadvantages. The market mechanism is no exception to this.

    Advantages

    Some advantages of the market mechanism are:

    • Allocative efficient. The market mechanism allows the free market to distribute goods and services efficiently without much waste and it benefits society as a whole.
    • Signals to investment. The market mechanism signals to firms and investors which goods and services are profitable and thus where they should invest and where they shouldn't.
    • No government intervention. Good and services are provided based on the invisible hand. Producers are free to produce whatever they want and consumers are free to buy whatever they want without the need for government intervention.

    Disadvantages

    Some disadvantages of the market mechanism are:

    • Market failure. Where there is no profit incentive to produce a particular good or service like healthcare or education, producers will not produce it, even if there is a necessity for it or high demand. Because of this, many vital goods and services are underproduced by the free market thus leading to market failure.
    • Monopoly. In the real world, there is sometimes only one seller of a good or service. Because of the lack of competition, they control the prices and supply of that good or service. Especially if this is a necessary good or service, consumers still have to buy it even if the price is too high.
    • Wastage of resources. In theory, there should be little to no wastage of resources as they are efficiently distributed, but in the real world that isn't always the case. Most firms value profits over efficient processes and this results in waste of resources.

    Market mechanisms: market failure and government intervention

    As we have said before, the main actors in the market are consumers, the firms (producers), and the owners of the factors of production.

    The market functions affect demand and supply. This interaction between supply and demand ensures efficient allocation of resources while helping achieve market equilibrium. This is why we can say that the market (forces of supply and demand) determines the best price and best quantity for both the producers and consumers.

    However, one disadvantage of the market mechanism, is that it can lead to market failure.

    Market failure is when there is an inefficient distribution of goods and services in the free market.

    When this occurs, government intervention is important. It enables the correction of market failure and the achievement of social and economic goals both as an economy and on a personal level.

    However, government intervention can also have negative effects on the market. This is known as government failure.

    Government failure is a situation where government intervention in the economy creates inefficiency and leads to the misallocation of resources.

    Market Failure, Government Intervention, and Government Failure are key concepts that link to the market mechanism. Check out our explanations for each topic!

    The Market Mechanism - Key takeaways

    • The market mechanism is a system of the market where the forces of demand and supply determine the price and quantity of goods and services traded.
    • The market mechanism relies on the invisible hand to fix market malfunctions.
    • The market mechanism has three functions: signalling, giving incentives, and rationing.
    • The market mechanism allows the market to move to an equilibrium point and distributes resources efficiently.
    • The market mechanism has some advantages: allocative efficiency, signals investment, and no government intervention. It also has some disadvantages: market failure, monopoly, waste of resources.
    • Government intervention is used when the market mechanism fails to correct market failure.
    Frequently Asked Questions about The Market Mechanism

    What is market mechanism?

    The market mechanism is a system of the market where the forces of demand and supply determine the price and quantity of goods and services. 

    What is the function of market mechanism?

    • Signals whether prices are too high or too low.
    • Incentivises to change the price of goods and services. 
    • Rations excess demands and supply.
    • Helps with the allocation of scarce resources.

    What is the market mechanism also referred to as?

    The market mechanism is also referred to as the 'Price Mechanism'.

    What are the advantages of market mechanism?

    • Helps ration goods and resources.
    • Gives a signal to producers on what to and not to invest in.
    • Determines income distribution amongst input owners. 
    • Gives producers complete freedom to decide what to produce.

    Test your knowledge with multiple choice flashcards

    What can create a shortage?

    Merit goods lead to _________ .

    Which of these is not an example of government regulation?

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