Readers Question: What is the role and function of price in the economy?
The price of goods plays a crucial role in determining an efficient distribution of resources in a market system.
Price acts as a signal for shortages and surpluses which help firms respond to changing market conditions
Example of How Price Influences the Economy
- As the supply of oil diminishes, but demand remains strong, this pushes up the price.
- As the price of oil rises it starts to change behaviour.
- Consumers look for more fuel efficient engines. People keener to buy cars which have a better fuel efficiency.
- People may start cycling rather than driving.
- Firms have incentives to develop cars which don’t run on petrol. (hydrogen powered cars, solar cars e.t.c)
- The higher price of petrol may create incentives to look for more oil reserves in previously untapped areas (e.g. Antarctic where it is expensive to extract oil). Therefore, in response to the higher price, supply may increase over time.
Therefore, in theory, price will help move an economy away from oil dependency to other means of transport and energy.
Some people think we will wake up one day and there will be no oil left and the economy will collapse. But, that is unlikely to happen. Price will create signals to firms and consumers to look for alternatives.
There’s an interesting article here at Freakonomics in 2005, saying the excitement over rising oil prices got exaggerated and the market mechanism would help create an efficient switch from oil to other sources of energy article
Economic systems - the free market