Market mechanisms

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Market mechanism is a process through which market economy functions. A market economy functions through the market forces of demand and supply. The demand and supply forces interact to determine the price of goods and services. Thus, a price system is generated. Prices perform two functions in the market system. First, prices serve as signals for the producers to decide "what to produce" and for the consumers to decide "what to consume" and "how much consume". Secondly, prices force the demand and supply conditions to adjust themselves to the prevailing prices [1].

Functions of the market mechanism

Market mechanisms answers the questions that come from the market [2] [3] [4] :

  • What to produce? - the goods and services that are produced in a market economy are determined by customer demand. The mechanisms through which individual values and interests are aggregated to make "consumer demand" is basewd on purchases. The consumer is "sovereign" in a free enterprise economy. Each penny a consumer spends on a commodity is treated as vote for producing that commodity. Continuing demand is a continuous process of voting. Increasing demand for a good causes increase in its price. Rise in price increases profit margin. The profit - seeking producers will concentrate on the production of this commodity, If they produce a commodity that is not in demand, it will go waste and their profit motive will be defeated.
  • How to produce? - is the question of choice of technology. Here technology means the technical combination of labour and capital. The proportion of labour and capital used to produce a commodity is also determined by the market forces, the supply of a demand for labour and capital. Firms produce for making profit and try to maximize it. It requires, among other things, minimizing cost of production. Cost can be minimized by using a factor combination that minimizes production cost. If labour is cheaper than capital then more of labour and less of capital is used to produce a commodity. On the contrary, if capital is cheaper or more productive, more of capital and less of labour is used. In fact, cost-minimizing firms combine labour and capital in such a proportion that minimizes the cost of production for a given output.
  • How much to produce? - market system forces - demand and supply - determine the quantity of a commodity that firms have to produce, given their objective of profit maximization. If the firms produce less than the quantity demanded, they leave out the prospect of selling more and making more profit. If firms produce more than quantity demanded, supply exceeds the demand. As a results, the price of their product goes down. Decrease in price reduces the profit margin (given the cost) or may even result in losses. So the firms cut down their production to match with market demand.

Equilibrium price on the market

The market equilibrium is found at the point at which the market supply and market demand curves intersect. The price at the intersection of the market supply curve and the market demand curve is called the equilibrium price, and the quantity is called equilibrium quantity. At the equilibrium price, the amount that buyers are willing and able to buy is exactly equal to the amount that sellers are willing and able to produce [5].

Examples of Market mechanisms

  • Auction: An auction is a market mechanism where buyers compete with each other to purchase the same good or service. The highest bidder wins the auction and pays the price determined by the auction. Common examples of auctions include online auctions, real estate auctions, and antique auctions.
  • Price Discrimination: Price discrimination is a market mechanism where a seller charges different prices for the same product or service to different consumers. The seller sets prices based on the consumer's willingness to pay. For example, movie theaters often charge a different price for adult tickets and children tickets.
  • Price Ceiling: Price ceiling is a market mechanism where the government sets a maximum price for a good or service. Price ceilings are often used to protect consumers from price gouging by companies. For example, the government may set a maximum price for essential items such as food, medicines, and fuel during times of crisis.
  • Price Floor: Price floor is a market mechanism where the government sets a minimum price for a good or service. Price floors are often used to protect producers from selling their goods and services below the cost of production. For example, the government may set a minimum wage for workers in order to protect them from exploitation by employers.
  • Subsidy: A subsidy is a market mechanism where the government provides financial support to producers of a good or service. Subsidies are often used to encourage production of certain goods and services that are deemed important for the economy. For example, the government may provide subsidies to farmers to encourage production of food crops.

Advantages of Market mechanisms

The advantages of market mechanisms include:

  • Allowing for efficient allocation of resources: Markets provide incentives for producers to allocate resources to the most productive activities, as those activities will be the most profitable. This leads to a more efficient allocation of resources, as resources are going to be used for the most beneficial activities.
  • Enhancing competition: Markets promote competition among many different producers and buyers. This encourages producers to produce more efficiently and to lower prices in order to attract more customers.
  • Providing price signals: Market prices act as signals to inform producers and consumers about the relative scarcity of a product. This helps producers to adjust their production and pricing decisions accordingly.
  • Flexibility: Markets are able to quickly adjust to changing consumer demands, allowing for a more efficient allocation of resources compared to other economic systems.
  • Promoting innovation: Markets reward innovative businesses for their ideas by allowing them to capture more of the market share. This encourages businesses to strive for creativity and innovation, which can lead to economic growth.

Limitations of Market mechanisms

  • One of the major limitations of the market mechanism is that it does not consider externalities. Externalities are the costs or benefits that are not captured in the market prices and are borne by third parties. This can lead to inefficient outcomes, such as over production or under production of certain goods and services.
  • Another limitation of the market mechanism is that it does not take into account the distributional effects of its decision making. This means that certain individuals may benefit from a certain market decision, while others may lose out. This inequality can lead to inequitable outcomes.
  • Additionally, the market mechanism does not consider the social and ethical implications of its decisions. For example, an increase in the price of a good may lead to a decrease in its consumption, which may have a negative social impact.
  • Finally, the market mechanism is also limited by imperfect information. This means that buyers and sellers may not have complete information about the goods or services they are trading and may thus be unable to make the most efficient decisions.

Other approaches related to Market mechanisms

Other approaches related to market mechanisms are as follows:

  • The Invisible Hand Theory: The Invisible Hand theory suggests that the market forces of demand and supply, when left to their own devices, will lead to the most efficient outcome for society. This theory is based on the principle of self-interest. According to this theory, when individuals pursue their own interests, this will lead to an efficient allocation of resources, which will benefit society as a whole.
  • The Rational Choice Theory: According to this theory, individuals are rational actors who make decisions based on their own self-interest. This theory suggests that individuals will seek to maximize their own utility and will base their decisions on cost-benefit analyses.
  • The Behavioral Economics Theory: This theory suggests that individuals are not always rational actors, and that their decision making is influenced by their emotions and biases. According to this theory, individuals are not always rational and may make decisions that are not optimal for them.
  • The Game Theory: This theory seeks to analyze the strategic behavior of individuals in certain market situations. It looks at how individuals will behave in certain situations and how this behavior affects the overall market outcomes.

In summary, other approaches related to market mechanisms include the Invisible Hand Theory, the Rational Choice Theory, the Behavioral Economics Theory and the Game Theory. These theories analyze different aspects of market behavior and how it affects the overall economy.

Market mechanismsrecommended articles
Law of supply and demandPriceCompetitive equilibriumFactors affecting pricingMonopsonFree competitionShort run equilibriumPrice-TakerFree market system



  1. Dwivedi D.N. (2008)
  2. Dwivedi D.N. (2016)
  3. Avant D.D. (2005)
  4. Walsh K. (1995)
  5. Sexton R.L. (2014)

Author: Aldona Pająk