Prices and the Allocation of Resources
In addition to rationing goods and services, prices also address the other two basic questions that must be answered by economic systems: what gets produced, and how does it get produced? A crucial role performed by prices is providing information. Prices transmit information about changing resource scarcity and changing consumer values.
Consider an increase in resource scarcity. What will happen if the world´s supply of oil begins to get exhausted? In an unregulated market, the price of oil will begin to increase. This signals consumers to use less of it and to switch to substitutes that are relatively more abundant. The rising price also signals producers to try to find more oil as well as to develop alternatives, such as solar power. That is also what we would like to see happen! It is the rising price that provides these incentives for both producers and consumers.
Now let us consider a change in consumers´ desires. Let us assume that, because of the proliferation of personal computers, people do not want as many typewriters as in years past. How does this information get transmitted to producers? The decrease in the demand for typewriters will cause the price to decrease. In response, quantity supplied will also go down. It works out nicely! People want fewer typewriters, so fewer resources are devoted to making them. Again, it is price that transmits this information from consumers to producers.
In addition to what gets produced, the question of how things are produced is addressed by prices. There are a lot of different ways to produce any particular good. A producer could use a capital-intensive production method or, alternatively, use a labor-intensive method. Let us use agriculture as an example. In less developed countries, farming activities such as planting, weeding, and harvesting are done by hand. In the United States, on the other hand, farming is generally more mechanized. Part of the reason for the different farming practices being used is that the price of labor is much lower in less developed countries. As the price of labor increases, producers will substitute capital for labor and become more capital intensive.