What is the role of the price mechanism in solving the basic economic problem?
The basic economic problem is scarcity. This problem comes about because of two factors. First, human beings have unlimited wants. Second, we have limited resources. Therefore, we experience scarcity because we have to try to fulfill our unlimited wants through the use of our limited resources.
The price mechanism does not make this problem go away. In fact, the problem of scarcity will always be with us. However, the price mechanism does allow us to strike a balance between our wants and our limited resources. The price mechanism serves at least three functions. It tells producers where resources should be used. If one sector of the economy has high prices, it needs more resources. Second, the price mechanism tells producers what people want. If the price of a good or service is going down, clearly people do not want as much of that product. As people’s tastes and desires change, prices transmit that information to producers. Finally, prices serve to ration scarce resources. They serve as a way to determine who is going to get how much of a given resource.
In these ways, prices tell us how to use our scarce resources to fulfill our unlimited wants in the best possible way.
Scarcity is a basic problem in economics. The issue is that resources are limited. These resources include money, land, mineral resources, and the things we want to buy. Price comes into play by helping us deal with these limited resources.
If the price is too low, there will not be enough of a given resource allocated for making the product. For example, if the price of designer shoes is too low, people will want to buy a lot of designer shoes. The problem is that the demand will be greater than the supply, causing the price to rise. This will inform producers that more resources should be used to make designer shoes. If the price of designer shoes is too high, the supply will be greater than the demand, causing the price to drop. This will inform producers that fewer resources should be used to make designer shoes. Thus, price helps bring supply and demand into a place or situation where supply and demand are about the same, allowing for the proper amount of resources to be allocated for making the product. As a result of the price mechanism, there should be enough resources to satisfy the demand.
Price plays an important role in dealing with the basic issue of scarcity.
What we are referring to when we mention the "basic economic problem" is the issue of scarcity—that is to say, the fundamental problem created by the unlimited nature of human wants and needs in a world that has limited resources.
Although price mechanism does not "solve" the basic economic problem in it and of itself (as scarcity does not ever "go away"), it is a very useful tool in solving the problems that result from scarcity. Price mechanisms help us handle the limited resources we have by doing several key things:
- Price mechanisms help determine what should be produced. If consumers are willing to meet a price set by producers, then producers will keep producing that product. If consumers are not willing to meet that price, producers will need to make a different product.
- Price mechanism determines where products are allocated. Individual consumers must decide if they want to (or even can afford to) meet the price set by producers. In this way, scarce resources are allocated more carefully.