What is the function of price in a free market economy?
In a free market economy the price of different products gives information about the demand and supply of the products. The price of products increases when the demand rises as there are more buyers willing to pay a larger amount for the same product. Price also goes up when the number of producers supply a smaller amount of the product as they are in a position to demand a larger amount for the same product.
The demand and supply in a free market is also a function of the price. As the price increases the demand goes down and the supply increases. On the other hand when the price goes down the demand rises and the supply decreases. The result of this feedback loop is the determination of an equilibrium price at which the buyers are willing to buy a particular quantity of the product and sellers are willing to sell the same quantity of the product.
Adam Smith is widely believed to be a proponent of the free market economy where competition drives prices up or down and the government has no role to play either in controlling prices or in helping producers. A more detailed study of his writing reveals that this is not the case and he in fact believed that governments should intervene when required to protect producers, buyers and keep prices within reasonable limits.
Price plays a very important role in a free market economy. Price indicates if resources are being properly allocated. If the price is too low, there will be a shortage of products. Demand will be greater than supply. This will indicate that more resources should be allocated to the manufacturing of the product. If the price is too high, there will be a surplus of products. Supply will be greater than demand. This will suggest that too many resources are being allocated toward the manufacturing of the product.
When supply and demand are equal, profit will be maximized. There won’t be too many items going unsold. There also won’t be the loss of income because too few items were produced. To maximize efficiency, producers need to determine the price where demand and supply are relatively equal.