Question

2. “A price is a signal wrapped in an incentive.” This statement encapsulates all of price theory. Explain what it means.

Answer 1

The given statement -

'A price is a signal wrapped in an incentive '

is the basis of solving the basic economic problem.It does encapsulates all of the price theory.Let us explain this.

When buyers and sellers interact in free markets, prices are set which enable goods, services, and resources to be allocated in the economy.Resources move towards where they are in the shortest supply( as prices are higher here) and away from where they are least demanded( low prices).

For Example;  Whenever resources become scarce at some point of time due to exogenous factors ( such as a natural disaster, a surge in demand due to increased income, fall in production etc. ) demand exceeds supply and prices are driven up. The effect of such a price rise is to discourage demand and conserve resources. The greater the scarcity the higher the price and the more the resource is rationed.In the long run higher price sends out signals, either for existing firms to introduce better production methods or by new firms entering the market. This causes the supply curve to shift to the right and cause new equilibrium quantity and price.

In free markets, Price mechanism is a system of signalling that ensures that demand and supply reach equilibrium situation and market is cleared.Price changes send signals to consumers and producers about whether to enter or leave a market. Rising prices give a signal to consumers to reduce demand or withdraw from a market completely, and they give a signal to potential producers to enter a market. Conversely, falling prices give a positive message to consumers to enter a market while sending a negative signal to producers to leave a market. This signalling function of price is true for any type of market be it consumer goods market, labour market, domestic market, international market, financial markets etc.

For Example; In the labour market when there is a rise in the wage rate( price of labour) it provides signal to the unemployed to join the labour market or to up their skills to meet the labour demand.

Further Prices acts as incentives that motivates a producer/consumer to follow a course of action or to change behaviour. Higher prices provide an incentive to existing producers to supply more because they provide the possibility of earning more revenue and increased profits. The incentive function of a price rise is associated with an extension of supply along the existing supply curve.When prices are low it increases the real purchasing power of the consumer.Suppose, a consumer who is buying a good at lower price now 'saves' on the money otherwise he would have spent on that good.This 'saved money' is a form of incentive which makes him buy either additional unit of same good or a different good.

To explain this further, Suppose if in an economy due to improved healthcare system, if price of obtaining healthcare fall downs then the income saved by a typical consumer acts as a kind of incentive that motivates the consumer to spend that money somewhere else (expanding the consumer goods basket like spend on tourism etc.) or save it for rainy days.

Similarly for producers if costs of raw materials falls down it increases their profitability that will eventually help them expand their business,hire more workers etc.

Such an incentive feature of price can be better understood if we consider a marketplace as an auction.

For Sellers -

Sellers set a minimum price below they have no incentive to sell.They are either not willing and/or able to sell at a lower price. Any price above the minimum price creates an incentive for the seller to sell the good. As the bidding or auction price increases so does his desire to sell. Thus higher prices increase his incentive to sell.

For buyers -

Buyers have a maximum price above which they have no desire to buy. They are either not willing and/or able to buy at a higher price. A price below this maximum increases the buyers desire / incentive to buy. A lower price makes buyers more willing and able to purchase goods and services. The further the price falls below this maximum price set by the buyers, the greater is the incentive to purchase the goods and services