The interaction of buyers and sellers in free markets enables goods, services, and resources to be allocated prices. Relative prices, and changes in price, reflect the forces of demand and supply and help solve the economic problem. Resources move towards where they are in the shortest supply, relative to demand, and away from where they are least demanded.
Whenever resources are particularly scarce, demand exceeds supply and prices are driven up. The effect of such a price rise is to discourage demand and conserve resources. The greater the scarcity, the higher the price and the more the resource is rationed. This can be seen in the market for oil. As oil slowly runs out, its price will rise, and this discourages demand and leads to more oil being conserved than at lower prices. The rationing function of a price rise is associated with a contraction of demand along the demand curve.
Price changes send contrasting messages to consumers and producers about whether to enter or leave a market. Rising prices give a signal to consumers to reduce demand or withdraw from a market completely, and they give a signal to potential producers to enter a market. Conversely, falling prices give a positive message to consumers to enter a market while sending a negative signal to producers to leave a market. For example, a rise in the market price of 'smart' phones sends a signal to potential manufacturers to enter this market, and perhaps leave another one. Similarly, the provision of 'free' healthcare may signal to 'consumers' that they can pay a visit to their doctor for any minor ailment, while potential private healthcare providers will be deterred from entering the market. In terms of the labour market, a rise in the wage rate, which is the price of labour, provides a signal to the unemployed to join the labour market. The signalling function is associated with shifts in demand and supply curves.
An incentive is something that motivates a producer or consumer to follow a course of action or to change behaviour. Higher prices provide an incentive to existing producers to supply more because they provide the possibility or more revenue and increased profits. The incentive function of a price rise is associated with an extension of supply along the existing supply curve.
A market starts with a stable equilibrium, where demand equals supply.
A supply shock reduces supply at each and every price. This creates an excess of demand at the existing price.
The price is now forced up to a new price (P1) where the market clears.
At the new price, demand and supply are brought into equilibrium through a contraction of demand (the rationing effect) and an extension of supply (the incentive effect).
In the long run, the higher price sends out signals, either for existing firms to introduce better production methods or by new firms entering the market. This causes the supply curve to shift to the right. Eventually, price may return to its existing level.
In conclusion, the price mechanism is said to work effectively through a combination of rationing, incentives and signals.