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In economics, a market mechanism refers to a system of market work in which the power of supply and demand determines the price and quantity of goods traded. This mechanism allows the market to go to a new equilibrium point when disequilibrium occurs.
The market mechanism is a description of how producers and consumers finally agree on price and quantity. Price serves as a signal for resource allocation.
Producers set prices based on profit considerations. Instead, consumers buy goods based on utility considerations. Both transact in the market.
The law of supply and demand ensures efficient allocation of resources. The power of supply and demand helps in achieving market equilibrium. In that condition, the market determines the best price and quantity, both for producers and consumers.
But, sometimes, the government tries to control the economic process. The government may issue policies such as price floor and price ceiling. Such interventions disrupt the market mechanism to work.
How the market mechanism works
For example, a business produces 60 shirts and sets its price at Rp170,000. In the market, it sells 10 shirts.
Because the sales quantity didn’t meet expectations, the business lowers the price to Rp130,000. It turns out that demand for selling well and 50 other shirts finally sold quickly. It finally realizes that the right price is Rp130,000.
In the example, the market mechanism works. Businesses respond by lowering the too-high price in response to market demand. The amount of Rp130,000 is the best price that consumers want to buy, and producers are willing to sell.
Prices outside of Rp130,000 are unreasonable for businesses and consumers. If the price of a shirt is Rp170,000, it is too expensive for consumers to afford it. If the price of the shirt is Rp120,000, the business will not accept it because it is unprofitable.
Effects of external intervention
In economics, the government often intervenes the market. Pro free-market economists don’t like such intervention. Interventions only lead to economic inefficiencies.
Equilibrium prices (market prices) convey a lot of information. The price increase is a signal for producers to increase production. And for consumers, it’s a signal to reduce demand. The opposite effect occurs when prices fall.
Hence, government intervention can disrupt the accuracy of such price information. Two government interventions that can disrupt market prices are:
- Price floor, such as minimum wage
- Price ceiling, such as rent control
The government sets both outside the equilibrium price. For effective intervention, the government sets a price floor above the equilibrium price and a ceiling price below the equilibrium price.
Because many countries do not adhere to a purely free-market economic system, government intervention will usually exist for public goods. Private companies may be reluctant to build roads because they are unprofitable in terms of business. Therefore, the government must intervene.
