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Price Mechanism Works In A Capitalistic Economy

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According to BuisnessDictionary.com, Price mechanism is defined as , System of interdependence between supply of a good or service and its price. It generally sends the price up when supply is below demand, and down when supply exceeds demand. Price mechanism also restricts supply when suppliers leave the market due to low prevailing prices, and increases it when more suppliers enter the market due to high obtainable prices.' Next, capitalistic Economy is defined as, 'Economic system based (to a varying degree) on private ownership of the factors of production (capital, land, and labor) employed in generation of profits. It is the oldest and most common of all economic systems and, in general, is synonymous with free market system.'

Over the next course of this project, examples of how capitalist economy will be explained and how the price mechanism works for them .

1.0 How price mechanism works in a capitalistic economy.

In a capitalist economy, all the central problems are dealt with the assistance a of price mechanism. In such an economy, no individual or firms deliberately tries to solve the central problems, instead all economic activities operate automatically and there are no conflicts anywhere to be found.

The main reason for all this is so that the price mechanism brings about coordination in various sectors of an economy system and in certain economic activities. The important or main characteristic of such a system is that it is automatic and independent and there are no institutions or agencies which may regulate or operate it.

The basis of price mechanism is that every commodity or service has a price in which it is determined with the help of demand and supply. Every commodity is dealt through buying or selling through a medium of currency (money). If a person sells his services or commodity, he gets money and with that he can buy goods and services which he needs. If there are more buyers of a product/commodity, its demand goes up and producers increase its production.

On the other hand, if a commodity is available in surplus, its supply increases, with the result its price shoots down and producers will therefore reduce its production. Whenever there is a difference or disequilibrium between supply and demand, price starts changing (either by going up or down), with the result this difference disappears and again an equilibrium is established between supply and demand.

In a capitalist economy, all the central problems are solved with the assistance of a price mechanism. Most central problems are dealt or can be asked through 'Wh' questions as in What, How , Whom etc. For example: -

What to produce?

In a capitalist economy, production of goods are decided by the forces of demand and supply. As the production of goods depends upon its demand and supply, in the same way as how an aggregate output is determined by an aggregate demand and an aggregate supply. The level of output where aggregate demand and aggregate supply are equal and is finally determine as an equilibrium output.

Also, In an aggregate output, what should be the quantities of different commodities? This decision is also made by the equilibrium of demand and supply of different commodities. The production of the commodity is increased when price goes up as a result of increase in its demand. On another hand, if the demand of a commodity declines, the production is then reduced.

How to produce?

Competition among consumers basically decides as to what goods should be produced, in a similar situation; the competition among the producers decides how goods in general should be produced. Goods can be produced by adopting several techniques. Usually the method or technology which is the cheapest will always be adopted and the one which is more expensive would be dropped.

Therefore, the decision on how goods should be produced solely depends on the prices of factors. A producer has to combine various factors for producing goods in such a way so that his/her production cost is as minimal as possible. For example, coal and diesel both can be used as a medium of fuel. If coal is cheaper in comparison to diesel, coal would be used and if diesel is cheaper then vice versa.

In this way, the choice of technique of production or the factor combination depends upon the factor prices. For example, In a country where there are abundance of hard labour and wages are low, more labour and less capital would be used. On the other hand, If a country has less hard labour power and more capital,then capital-intensive techniques would be deployed.

For whom to produce?

In a capitalist economy, production of commodities depends upon the buying capacity of the consumers in the market. It is well known that the paying capacity of a consumer depends directly on his purchasing power or his income. Besides this, the income of a consumer depends upon how much of his services that are demanded. The higher the demand for a person's services, the more higher would be his income. If the income of a consumer is more, his capacity to purchase most definitely will be more. In such situations, production will be carried out for such people whose incomes are higher or those who can afford so.

Therefore, in a capitalist economy, it is well noted that price-mechanism facilitates more production of luxuries meant for rich people and less production of goods of mass consumption which in contrary are meant for poor people.

How demand and supply curves are derived using some data on demand for and supply for certain goods or services .


Based on www.businessdictionary.com, Demand and Supply are defined as, 'Economic forces fundamental to the price mechanism in a free market system. They determine the price of a good or services offered, and are in turn determined by the price obtainable. It is a largely self-regulatory mechanism generally resulting in market equilibrium where products demanded at a price are equaled by products supplied at that price.' Goods and services meanwhile, are defined as, 'The most basic products of an economic system that consist of tangible consumable items and tasks performed by individuals. Many business portfolios consist of a mix of goods and services that they offer to potential consumers via a sales force.'

The Law of Demand

Demand, in economic terms, illustrates how much of a product consumers are willing to buy, at different price points, during a certain period of time.

After all, resources are limited, and everyone has to decide what they are willing and able to purchase and at what cost. For example, let's look at a simple model of the demand for a necessary good, gasoline.

If the price of gas is $2.00 per liter, on average people will be able to purchase 50 liters per week,. If the price drops to $1.75 per liter, they may be able to purchase 60 liters. At $1.50 per liter, they may well be prepared to purchase 75 liters. Therefore, as gas prices drop, people may choose to make more trips during weekends, public holidays, and holidays.

Buyer Demand per Consumer

Price per liter

Quantity (liters)

demanded per week











This schedule, illustrates the law of demand: as price drops, the corresponding quantity demanded tends to rise. Since price is an obstacle, the more greater the price of a product, the less it is demanded. When the price drops, the demand increases.

So, an "inverse" relationship between price and quantity demanded will be created or noted. When you graph the relationship, a downward-sloping line is present, like the one shown in figure 1 below:

To create a market demand curve for gasoline, individual demand is totaled and combined.

The Law of Supply

While demand is the customers' side of purchasing decisions, supply relates to the producer's desire to make profit. A supply schedule typically shows the quantity of product that suppliers are willing and able to produce to make available to the market, at specific price points, during a certain time period. In short, it displays to us the quantities that suppliers are willing to offer at various prices.

This takes places because suppliers tend to have different costs of production. At a low price, only the most efficient producers can make a profit, so only they produce. At a high price, even high cost producers can make a profit, so everyone produces.

Using the gasoline example, It shows that oil companies are willing and able to supply certain amounts of gas at certain prices, as seen below

Gas Supply per Consumer

Price per liter

Quantity (liters)

supplied per week











At a low price of $1.20 per liter, suppliers are willing to provide only 50 liters per customer per week. If customers are willing to pay $2.15 per liter, suppliers will provide 120 liters per week.

As the prices increase, the quantity supplied rises as well. As price falls, so does the supply. This role here is a "direct" relationship, and the supply curve has an upward slope.

Figure 2: Example supply schedule for gasoline using supply schedule.

Because suppliers want to provide their products at high prices, and consumers want to purchase the products at low prices, how is the price of goods actually set? Let's relate back to our gas example. If oil companies try to sell their gas at $2.15 per liter, do you think they'll sell as much? Most probably not . Yet, if the oil companies decides to lower the price to $1.20 per liter, consumers will be very happy, but will the price be enough to make profit? And furthermore,the most important question of them all, will there be enough supply to meet the higher demand by consumers? The answer is simply No.

Equilibrium: Where Supply Meets Demand

Equilibrium is the point where there is an equality between quantity demanded and quantity supplied. This means that there is no surplus of goods and no shortage of goods. A shortage takes place when demand is greater than supply, meaning when the price is too low. A surplus takes place when the price is too high, and consumers don't want to purchase the product.

The fabulous thing about the free market system is that prices and quantities tend to direct towards equilibrium and at most times it helps keep the market stable.

For example, At $1.20 per liter, consumer demand exceeds supply, and there's a shortage of gas in the market. Shortages tend to increase the price, because consumers compete to purchase the product. However, when prices drastically increase, demand decreases, even though the supply may be available. Consumers may start to purchase substitute products, or they might not purchase anything at all. This creates a surplus. To eliminate the surplus, the price goes down and consumers like before starts buying again. In this order equilibrium is usually maintained quite efficiently and well.

In our gas example, the market equilibrium price is $1.50, with a supply of 75 liters per consumer per week, as shown in figure 3.

Market equilibrium explains movement along the supply and demand curves but at the same time ,it doesn't explain changes in total demand and total supply.

Changes in Demand and Supply

Changes in price initially results in a movement along the demand or supply curve, and It directs towards changes in quantity which are demanded or supplied.

If consumers for example are faced with an extreme change in the price of gas, their trend for demand for gas changes. They not only start by choosing different means of transportation - like taking the public bus or cycling to work- but, they also start purchasing more fuel-efficient vehicles like compact cars, motorcycles, or scooters. The effect is a drastic change in total demand and a huge shift in the demand curve. The schedule for demand is now Demand 2, shown below.


Although the phrase "supply and demand" arises commonly, it's not always understood in proper economic terms. The price and quantity of goods and services in the marketplace are determined by consumer demand and the amount that suppliers are willing to supply.

Demand and supply can be plotted as curves and the curves that meet at the equilibrium price and quantity. The market at most times tends to naturally head toward this equilibrium and when total demand and supply shifts, the equilibrium moves accordingly. To me and in general, It is a relationship that determines what happens in a free market economy. If you understand how these factors influence supply, pricing and purchasing decisions, it will help analyze the market much better hence making us make better decisions when we are shopping or purchasing goods in the future.

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