This page provides an overview of the market mechanism by describing what it is and how it works to allocate resources in an economy. If you already have a good understanding of markets (including the use of demand and supply curves) you could skip to the next section [price elasticities]. Alternatively, work through each of the sub-pages within the ‘market mechanism’ tab, where a more comprehensive coverage of the market mechanism is provided.
The market or price mechanism describes how the forces of demand and supply determine (relative) prices of goods and services which then ultimately determines the way our productive resources (e.g. labour and capital) are allocated in the economy. As prices change in various markets, for example, because demand is very strong, it sends a signal to suppliers that profit opportunities exist if they direct resources, such as labour and capital, into those areas experiencing higher demand. In this respect, it is consumers who ultimately determine what is produced (and therefore where resources are allocated) via their demands for goods and services. This is sometimes referred to as consumer sovereignty.
For example, with advances in technology and changing consumer preferences, some products become increasingly obsolete. Take for instance ‘tablets’ (e.g. the ipad) replacing ‘PCs’ for many consumers. In the market, we would observe a drop in the demand for PCs and an increase in the demand for tablets. This results in a change in the relative prices of goods and services. The price of PCs will fall relative to the price of tablets because fewer consumers are demanding PCs and instead demanding tablets. This is reflected in the demand curve for PCs falling from D1 to D2 and the demand for tablets increasing from D1 to D2. Suppliers will then devote fewer resources (e.g. labour and capital) to the production of the PCs, which is reflected in a contraction along the supply curve and less production (Q1 to Q2). In contrast, suppliers will devote more resources to the production of tablets as the demand and price has increased. This is reflected in an expansion along the supply curve for DVD players and more production (Q1 to Q2).
Overall, the change in technology, combined with changing consumer preferences, results in more tablets being produced relative to PCs and a shift in the allocation of resources from PC to tablet production.
It is always important to remember that the increase in relative prices of tablets when compared to PCs is the signal provided by ‘the market’ that results in producers allocating more resources to tablet production.