Price System
Vinod Anand | 25 Aug 2013

Price System (Vinod Anand) This refers to the system of resources allocation based on the free movements of prices. In an economy in which markets are permitted to work without outside intervention, the decisions taken by individual buyers and sellers are coordinated and made consistent with each other by movements in prices. Thus, if buyers wish to1 purchase more than sellers wish to supply, price will rise. As price rises, this causes buyers to reduce the quantities they wish to buy, and sellers to increase the quantities they wish to sell, until, at some particular price, these quantities are equal, and the separate decisions of buyers and sellers are thus made consistent. Similarly, if sellers wish to sell more than buyers are prepared to take, price falls, causing sellers to reduce the quantities they wish to sell, and buyers to increase the quantities they wish to buy, until the quantities are again equal, and decisions are consistent. If every good, service and factor of production of production in the economy is sold on such a market, then we can see how the movements in prices bring about consistency of decisions or plans of all buyers and sellers, This mechanism by which movements in prices coordinate individual decisions is known as the price system. Several things should be noted. First, the process of coordination is quite decentralized. No single central authority collects information on buyers’ decisions and sellers’ decisions, finds the level at which they are consistent and then transmits information on the necessary sales and purchases to individual buyers and sellers. Whatever one’s view of the ethics of centralization, a decentralized system is, other things being equal, likely to be more efficient as a coordinating device; simply because it saves the costs of a two-way transmission of information, it may operate more quickly and with fewer mistakes. Secondly, however, we must take care not to identify too readily the workings of the idealized price system with the workings of any actual free market economy. Many frictions and imperfections may exist in the real world which may be judged to tilt the balance of efficiency from the decentralized price system to a centralized planned economy — although state ownership of the means of production by no means precludes the use of a price system to solve the technical problem of resource allocation. Finally, even if markets in the real world worked smoothly, without frictions and imperfections, the price system does not solve all the problems of resource allocation. Some goods, often called public goods, cannot be bought and sold on markets. The price system does not take into account externalities, and so does not ensure that the socially optimal level of an activity is in fact achieved. The ability to buy goods and services through the price system depends on one’s income, and this may create social problems. The conditions under which the price System will bring about an optimal allocation of resources forms a major area of study of welfare economics.