Chapter 4, Problem 4.1LO

To determine

The price system.

Explanation of Solution

The prices are an expression of consensus on the value of goods, services and factors in the economy. It is a standard measure of value across the globe which is one of the guiding principles of policy decisions. The price system is called the “Invisible Hand” and is the chief connecting mechanism between the two economic agents Consumers and Producers in the laissez faire economy.

The essential features of the price system are:

1. It is neutral: The operating principle of the price system is neutrality which implies that neither of the two communicating agents in the economy can determine the prices in isolation and to the exclusion of the other. In other words, in determining the prices of goods and services both producers and consumers interact in the commodity market through the forces of demand and supply to establish the equilibrium price. Monopoly, however, is an exception where the monopolist fixes the prices swayed by the profit motive.
2. Prices are market driven: The prices are determined by the economic forces of demand and supply. Prices are determined at the point of interaction of the demand and supply curve. This is shown in the figure below:



Any deviation between the demand and supply of the commodity activates the forces of demand and supply and the invisible hand of the market forces re-establishes the equilibrium. For example if demand exceeds supply the prices increases. The increase in the prices, reduces the demand and the process of adjustment continues till demand equals supply.

3. Prices are flexible: The prices in the free market determined by the forces of demand and supply are flexible. They respond to the economic fluctuations and serve as the stabilizing economic mechanism. The prices quickly respond to the economic changes through the bidding process by the consumers and producers.
4. Efficiency: The prices ensure efficient allocation of resources until the maximum number of goods and services are sold. The system ensures making the best use of the available resources. This is technical efficiency. Producing the maximum possible output with the available resources is economic efficiency. The price system ensures both technical and economic efficiency.

Economics Concept Introduction

Introduction:

Price System: It is a quintessential foundation of any economic system whereby all goods and services and all factors of production are valued in terms of money. This value is its price and the key factor in the production and consumption decisions in the economy.