Functions of Price and its effectiveness in market economy 

Explain the functions of price in resource allocation and consider the importance of these functions in relation to the potential effectiveness of a market economy. [8] 

Price plays an important role in efficiently allocating resources within a market as it performs rationing, signaling and incentivising functions in a market economy. A market economy is an economic system that has no government intervention in the operation of the market. Unlike planned economies the decision to what to produce, how and to whom to produce is decentralised.

Price communicates scarcity of the resources in the economy. As price changes, it shifts consumers’ preference towards goods or services. This is because as price changes, consumers' utility towards the goods changes therefore consumers may shift their priorities on whether to consume more or less of a good. Hence price successfully allocates resources to the most valued goods in the economy ensuring efficiency in allocation of resources.

Price sends signals to the producer about consumers preferences. As price changes due to shifts in demand, supply or both, producers get the signal whether to allocate more or  less resources towards the production of the goods or services.  For example, an increase in the price of good A will send a signal to the producers about possible higher profit to be made, therefore producers will divert production resources to produce more of the good A. 

Lastly, price also incentivises both producers and customers towards the most efficient allocation of resources. Increase in price will incentivise producers to produce more as they can gain more profit , whereas decrease in price will encourage consumers to consume more as they earn more utility. The interplay between the two agents incentives and price ensures welfare is maximised through resources being allocated in the most efficient manner.

In a market economy, price plays a crucial role. Price sends signals for agents in the economy to make informed decisions. Without price signaling, it would be very difficult to gauge relative scarcity. There will be lack of information to show consumers preference hence the interplay that incentivises the resource allocation will also be missing. Furthermore, price helps the market economy to adapt quickly to both positive and negative supply shocks.  Hence minimising waste in the economy.

The effectiveness of the market economy relies heavily on  price functioning effectively as has been demonstrated above. However, price can also contribute towards market failure in the market economy. Resources may be under-allocated or overconsumed in certain circumstances. The efficient working of price mechanism is only effective when all agents in the economy have full information about the market. In reality information asymmetry occurs leading to misinformed decisions. For example, lack of knowledge on full effects of cigarette smoking could lead to price not reflecting the true value of the good leading to overconsumption hence overallocation of resources to cigarette production.

In conclusion, price ensures smooth market economy operation. Price rations resources efficiently by prioritising consumers preference, while signaling the market to coordinate resources constantly as it helps to transfer consumer preferences in production of goods and services. At the same time price incentivises productive behavior in the market. As a result, price enables optimal social outcome with maximum producer and consumer surplus in the market economy. Price serves as an important tool in the working of an effective market economy even though there are certain circumstances that may result in market failure.