Market Mechanism

The market mechanism in economics refers to the function of supply and demand to determine the commercial value of goods and services sold in the market. Consequently, producers and consumers agree on this price and quantity sold. It forms the basis of all the market transactions.

It operates in a free market system, utilizing supply and demand forces to establish stability, efficiency, and resource allocation. It is an extension of Adam Smith's concept of the invisible hand, which guides economic activities. Through the interaction of buyers and sellers, market equilibrium is achieved, optimizing the allocation of resources.

• The market mechanism can be defined as the natural process through which the market arrives at the optimum value of goods and services and the quantity sold. It is essential in resource allocation and price determination.
• The results of such an automated commercial activity are ideal as any external interventions, such as corporate monopoly or government regulations, will disrupt the mechanism.
• The stock market mechanism is a function of the number of available shares in a particular company and the investor's demand to hold its equity relative to its price.

The market mechanism in economics is one of the most natural processes that occur in the economy. Though there are many principles and concepts in theory, consumers and producers do not knowingly apply these in practice. They act in their self-interest, and that guides the market's direction. It should ultimately lead to market equilibrium and efficiency.

The cost of production per pen is $20. In that case, there will be no profit for the producer if the consumers only bought the pen at $20. Thus, the producer sells at $21, and the consumers would realize that the price wouldn't go below this and would start buying it anyway.

In a perfect market where the producers can correctly anticipate the demand, they would optimize their supply accordingly. For example, if the producer has nine regular customers every month but anticipates an extra customer, they would only produce ten pens monthly. Here supply equals demand, and the producer can make a satisfactory profit.

Though this might only sometimes be the case, the producer must manufacture more to meet any additional consumer demand. Otherwise, there would be a supply-demand gap.

The free market mechanism is mainly seen in capitalist economies. A free market has no restrictions on who can enter, leave, or sell at any price. However, in a capitalist economy, the lack of basic regulations like a price ceiling might be unfair to customers. In a mixed economy, the mechanism is visible, with the state employing minimum restrictions to protect customers and producers.

Here, it is noteworthy that the concept also applies to stock and exchange markets. For example, the stock market mechanism regulates the supply of equities and other securities in a particular company regarding customer demand. Thus, companies sometimes resort to increasing the number of shares to accommodate more investors.

The market mechanism has three primary functions:

1. Signaling function – As the term suggests, any price changes will signal the market participants, who can then influence the supply and demand forces in the market. So, when a company lowers the price, the consumers will buy more, thus increasing demand, altering supply, and so on.
2. Incentives function – This function concerns producers, who are incentivized to produce more with any changes in price or other factors. For example, during the onset of the COVID-19 pandemic, consumers would have bought facemasks at higher prices too.
3. Rationing function – Economics is based on the scarcity of resources. When this happens, supply falls, and demand increases, causing a price hike. In such cases, customers ration the goods by purchasing as much as they can afford or switching to alternatives. Rationing is a common practice during war times.

Let's discuss a few examples to understand the market mechanism.

Example #1

ElectroXYZ is a technology company. It recently launched a music system with advanced features. Many market experts called it a disruptive technology. The company's cost of production per unit is $8000. Here's the quantity supplied and sold, with the price per quantity on different days.

From this, the company understood that the optimum price for the music system, as perceived by the market, was $10,000.

Example #2

Morgan Stanley predicts that the oil supply in the third and fourth quarters of 2023 will tighten with demand recovery. The increase in demand is likely due to China reopening its borders, aviation recovery, and other factors. Morgan Stanley predicts the Brent prices to remain at $80 - $85 in the first quarter. The price can increase to $110 per barrel with the demand spike.

Here are the merits and demerits of the market mechanism.

Advantages

• The ideal price and quantity are arrived at naturally by the actions of the market participants. It contributes to market equilibrium and efficiency.
• Such a market functions without any restrictions or regulations from the government, thus maximizing gains.
• In capitalist economies, it encourages competition, increasing market efficiency, innovation, etc.

Disadvantages

• The concept is highly theoretical, considering government interventions and other factors in the real world. Thus, market failure is not a distant possibility.
• It doesn't account for the environmental damages such a process might cause, especially in a free market economy.
• In capitalist economies, the exploitation of laborers and disparity in wealth cannot be ruled out.

The market and price mechanisms are closely intertwined concepts that significantly impact an economy's functioning. Although they are closely related, it is essential to understand the specific differences between these two mechanisms.

• The market mechanism encompasses the overall process of coordinating the interaction between producers and consumers. The price mechanism, on the other hand, is a specific aspect of the market mechanism. It refers to how prices adjust based on the forces of supply and demand to reach equilibrium.
• The market mechanism includes supply, demand, production costs, consumer preferences, and competition to establish the equilibrium price and quantity of goods or services. On the other hand, the price mechanism focuses explicitly on how the interaction of supply and demand influences the adjustment of prices, which is determined by the relative scarcity or abundance of a product in the market.
• The market mechanism involves the decision-making processes of both producers and consumers. The price mechanism primarily focuses on the decision-making process of consumers.

While the market and price mechanisms are distinct, they are interrelated and work together to facilitate efficient resource allocation and determine market outcomes.

This article has been a guide to What Is Market Mechanism. We explain its examples, functions, advantages, disadvantages, and relation with price mechanism. You may also find some useful articles here -

• Monetary Transmission Mechanism
• Imperfect Market
• Exchange Rate Mechanism