The role of price mechanism in a free market economy or capitalism! The price system functions through prices of both goods and services. Prices determine the production of innumerable goods and services.
They organise production and help in the distribution of goods and services, ration out the supplies of goods and services and provide for economic growth. Let us analyse the role of prices in all these spheres. (1) What and How Much to Produce:
The first function of prices is to resolve the problem of what to produce and in what quantities. This involves allocation of scarce resources in relation to the composition “of total output in the economy. Since resources are scarce, the society has to decide about the goods to be produced: wheat, cloth, roads, television, power, buildings, and so on. Once the nature of goods to be produced is decided, then their quantities are to be decided. How many kilos of wheat, how many million metres of cloth, how many kilometers of roads, now many televisions, how many million kw of power, how many buildings, etc. Since the resources of the economy are scare, the problem of the nature of goods and their quantities has to be decided on the basis of priorities or preferences of the society. If the society gives priority to the production of more consumer goods now, it will have less in the future. A higher priority on capital goods implies less consumer goods now and more in the future. This problem can be explained with the help of the production possibility curve, as shown in Figure 7.1. Suppose the economy produces capital goods and consumer goods. In deciding the total output of the economy, the society has to choose that combination of capital and consumer goods which is in keeping with its resources.
It cannot choose the combination R which is inside the production possibility curve PP, because it reflects economic inefficiency of the system in the form of unemployment of resources. Nor can it choose the combination K which is outside the current production possibilities of the society. The society lacks the resources to produce this combination of capital and consumer goods. It will have, therefore, to choose among the combinations B, C or D which give the highest level of satisfaction. If the society decides to have more capital goods, it will choose combination B and if it wants more consumer goods, it will choose combination D. (2) How to Produce:
The next task of prices is to determine the techniques to be used for the production of articles. Prices of factors are the rewards received by them. Wage is the price for the service of labour, rent is the price for the service of land, interest for the service of capital and profit for the service of entrepreneur. Thus wages, rent, interest and profit are the prices paid by the entrepreneur for the services of the factors of production which make up the costs of production. Every producer aims at using the most efficient productive process. An economically efficient production process is one which produces goods with the minimum of costs. The choice of a production process will depend upon the relative prices of the factor services and the quantities of goods to be produced. A producer uses expensive factor services in smaller quantities relative to cheap resources. In order to reduce costs of production, he substitutes cheaper resources for the dearer. If capital is relatively cheaper than labour, the producer will use a capital-intensive production “process. Contrariwise, if labour is relatively cheaper than capital, labour-intensive production processes will be used. The technique to be used also depends upon the type and quantity of goods to be produced. For producing capital goods and large outputs, complicated and expensive machines and techniques are required. On the other hand, simple consumer goods and small outputs require small and less expensive machines and comparatively simple techniques. (3) To Determine Income...
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