Price Signal

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A price signal is a message sent to consumers and producers in the form of a price charged for a commodity; this is seen as indicating a signal for producers to increase supplies and/or consumers to reduce demand.

Free price system

Main article: Free price system

For example, in a free price system, rising prices may indicate a shortage of supply, increase in demand, or a rise in input costs. Regardless of the underlying reason—and without the consumer needing to know the cause—the price increase communicates the notion that consumer demand (at this new, higher price) should recede or that supplies should increase. Consumers that do continue to purchase the product at the higher price ostensibly give the product a higher marginal utility. This results in a natural market correction, according to the Austrian theory of catallactics.

In a fixed price system where prices are set by government, price signals may not be as reliable as indicators of shortages, surpluses, or consumer preferences according to opponents of planned economies. These artificial prices may create shortages and surpluses that would not occur under a free price system.

An alternative theory of centrally planned economies, the shortage economy theory of Hungarian economist János Kornai argues that it is not a failure of the pricing mechanism, but rather a systemic failure to produce enough goods, since shortages were obvious but persisted.

Alternative theories

How prices are set is a key question in the theory of industrial organization. The theory of price signals argues that higher prices reflect either increased consumer demand (thus spurring higher production), or increased producer costs (thus reducing consumption), allowing the coordination of the economy. For example, if a producer charges a fixed percentage markup, then prices reflect costs of production, and changes in price correspond to changes in production, rather than changes in profit.



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