What is the role of the price mechanism in solving the basic economic problem?

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

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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.