We sometimes think of prices as being the equilibrating mechanism, to use an economist s jargon. We can all understand a situation whereby if prices are too high people go away, they ll just leave the market place. They won t be interested in buying.
Likewise if prices are too low, the sellers won t be prepared to sell. They ll simply take their prduce home.
And so prices adjust in markets so that we can get to a situation when people are reasonably satisfied and, essentially, what the sellers want to sell is more or less what the buyers want to buy in terms of quantity.
And so there is an equilibrium in the market.
Prices become the lever through which the quantities that people want to sell are equal to the quantities that people want to buy.[
The role of the prices in the economy is several-fold. At the crudest level, prices provide an incentive for production. The higher the price, the more that people who produce will swing in to an industry and try and produce.
Prices also ration demand. That is, consumers would have unlimited demand for certain products if they re given away free. But if they are charged for them in accordance with the cost of making them, then that will ration demand and bring demand and production into an appropriate balance. So that s the first two roles of prices.
But prices also have a signalling function. That is they send a signal to producers that it s better for them to produce x where x has a high price, than y, where y has a low price and is not valued very highly by consumers.
Prices generally play an incentive role. They give incentives to producers to produce or not produce, depending on their level. They give incentives to consumers whether or not to consume particular goods.