How does price-mechanism solve central problems in an economy?



In a capitalist economy, all the central problems are solved with the help of price mecha­nism. In such an economy, no individual or a firm deliberately tries to solve the central problems; all economic activities operate automatically and there is no conflict anywhere.

The basic reason for all this is that price mechanism brings about co-ordination in various sectors of economy and in various eco­nomic activities. The important characteristic of such a system is that it is automatic and there is no institution or agency which regulates or operates it.

The basis of price mechanism is that every commodity or service has a price which is determined with the help of supply and demand. Every commodity is bought and sold through money. If a person sells his services or commodity, he gets money and in lieu thereof he can buy goods and services which he needs. If there are more buyers of a commodity, its demand goes up and producers increase its production.

On the other hand, if a commodity is available in abundance, its supply increases, with the result its price goes down and producers reduce its production. Whenever there is a difference or dis­equilibrium between supply and demand, price starts changing, with the result this difference disappears and again an equilibrium is established between supply and demand.

demand and supply curves intersect each other at point E where price is OP and equilibrium output OQ. According to the schedule equilibrium price will be Rs. 10 because at this price demand and supply are equal.

In a capitalist economy, all the central problems are solved with the help of price mechanism. Now we would sec as to how all the central problems—what to produce, how to produce and for whom to produce—arc solved with the help of price mechanism.

1. What to produce?

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

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

2. How to produce?

As the competition among consumers decides as to what goods should be produced, in the same way, the competition among the producers decides as to how goods should be produced. A commodity can be produced adopting a number of techniques. The method or technology which is the cheapest is adopted and the one which is costlier is abandoned.

Therefore, the decision as to how goods should be produced depends on the prices of factors. A producer combines various factors for producing a commodity in such a way so that his production cost is minimum. For example, coal and diesel both can be used as fuel. If coal is cheaper in comparison to diesel, coal would be used and reverse would be the case if diesel is cheaper.

In this way, the choice of technique of production or the factor combination depends upon the factor prices. In a country where there is abundance of labour and wages are low, more of labour and less of capital! would be used. On the other hand, in a country where there is less of labour and more of capital, capital-intensive techniques would be used.

3. For whom to produce?

In a capitalist economy, production of commodities depends upon the buying capacity of the consumers in the market. It is a well known fact that the paying capacity of a consumer depends upon his purchasing power or his income. Besides this, the income of a consumer depends upon the fact as to how much his services are demanded. Higher the demand for a person's services, higher would be his income. If the income of a consumer is more, his capacity to buy is more. In such a situation, production will be carried out for such persons whose incomes are more or who can pay.

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