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The pricing mechanism is an economic concept that relies on a free market system, where the price of a product depends on supply and demand. It helps achieve balance in the economy by reflecting the action and reaction of the entire market. The mechanism acts as a rationing agent for products with inverse proportionate demand and supply.
Pricing mechanism is an economic concept that refers to how the price of a product depends on the supply and demand for that product. First posited by economist Adam Smith, the concept relies on the functioning of a free market system for its existence. Just as the price of a product will react to changes in supply and demand, so too will supply and demand respond to a change in price. Thus, the price mechanism helps to achieve some kind of balance between all elements of an economy.
One of the key features of a free market economy is how the decisions made by millions upon millions of consumers will affect how products are produced and the price of those goods. None of those seemingly disparate elements show up in a vacuum. Instead, they all depend on each other and react to moves up and down the supply and demand curve. Thus, the price mechanism reflects the action and reaction of the entire free market.
For example, imagine there is a sudden demand for light bulbs among members of society. As demand increases, light bulb manufacturers will be able to raise the price of light bulbs to reflect that demand. In turn, the company that makes the bulbs will devote more of its manufacturing efforts to the bulbs, thereby increasing supply to meet demand.
With this example, the pricing mechanism resulted in the initial increase in the prices of light bulbs. As the initial demand for bulbs has been met and increased production has resulted in more bulbs being produced, the mechanism starts to backtrack. Rising prices and increased supply will result in lower demand for light bulbs. Once that happens, prices will drop again, companies will once again scale back their efforts to produce the bulbs, and the cycle will return somewhere near its original starting point.
If the demand for a particular product increases in inverse proportion to the supply, the price mechanism acts as a sort of rationing agent for that product. The price will rise to keep demand low until supply levels can catch up. As a result, prices can fall again.
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