Ways how price mechanism or market mechanism solves the central economic problems in a capitalist economy are given below:
Ways
1. Solution of ‘what to produce’:
What to produce means what commodities and what quantity of each chosen commodities will be produced and in what quantity is decided by what buyers prefer to buy.
The preference of the buyers affects equilibrium prices of goods. The equilibrium prices serve as guide to firms to decide which commodities and what quantity of different goods is produced.
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In a free market economy firms want to maximize profits. Those commodities will be produced more whose demand is more and vice- versa.
When the demand of particular goods increases, its price will increase. Other thing remaining same, a rise in the price of goods will result in more profit.
The increase in profit will induce the producer to increase the production of that commodity. On the other hand fall in the demand of goods will reduce its price.
The fall in price will reduce the profits or may cause lose. Therefore, the producer will reduce the production of those goods and will transfer the resources in the production of those commodities whose prices have raised to cam more profits.
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For example, if the demand for automobiles increases, the prices of automobiles will rise in the market.
This will be a signal for the producer to transfer factors inputs in the production of automobiles. If the demand for cotton garments falls, the production of cotton garments would decrease.
Thus, in a capitalist economy what and how much to produce is decided by the forces of demand and supply, i.e., by price mechanism.
The price mechanism ensures that factor inputs arc allocated in the production of desired goods in desired quantities.
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Now it is amply clear that in a capitalist economy, the issue relating What to produce and in what quantity is decided ultimately by the preferences of the consumers exhibited by their demand for goods.
Thus, consumer acts like a sovereign king to give direction about what be produced and in what quantity.
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2. Solution of ‘how to produce’:
How to produce refers to the choice of technique of production. Again the aim of firms is to maximize their profits.
Profits are the difference between the revenue receipts and cost of production. Incurred profits are maximized when a producer produces the goods and services at least cost combination, i.e., the cost of production is minimized.
Which technique of production or which combination of factor inputs will minimize the cost of production of a given level of output depends on the relative prices of factor inputs.
The prices of factor inputs are determined by price mechanism, that is, by the forces of demand and supply of factor inputs in the factor market.
If labour is relatively cheaper than capital, producer will prefer labour-intensive technique of production and vice-versa.
In order to achieve least cast combination of factors of production, the producer will combine the factor inputs in such combination that:
VMPn/ Pn = VMPk /PK
Where VMPN is value of marginal productivity of labour and VMPk is the value of marginal product of capital.
PN is the price of labour and PK is the price of capital out of fear of competition and to earn maximum profits.
All the producers in capitalist economy try to use most efficient and economical technique of production. Competition throws the inefficient firms out of market.
If the factor endowment of the economy and relative prices of factor inputs changes, there will be change in the techniques of production.
History is filled with examples how inefficient methods of production are replaced by efficient methods of production.
It is clear from the circular flow diagram that goods produced by production sector are supplied to the households through the product market. Households consumption preferences represent demand side of the product markets.
The interaction of demand and supply determines equilibrium prices of goods; equilibrium prices direct the production sector about what and how much to produce.
The household sector supply factor senders to the production sector through factor market. The production sector demands factors services.
The demand and supply forces determine factors prices. Thus, factor market by determining factor prices determines the income of households and affects the demand for goods and services.
On the other hand on the basis of factors prices, the production sector decides how to product. The factor market, helps in deciding two issues how and for whom to produce.
Now it is clear from the above analysis how market forces of demand and supply operating simultaneously in both product and factor markets solve all the three problems simultaneously.
3. Solving for ‘whom to produce’:
It is essentially a problem of distribution of national output among factors of production. In fact, goods are produced for those who have purchasing power and the desire to buy.
Purchasing power depends on money income. Money income of household depends on the rewards of factors of production on the one hand and amount of ownership of resources on the other hand.
Price of factors of production are determined by the interaction of their demand and supply. In other words price mechanism determines factor prices.
Thus, the distribution of national income among people is determined by the ownership of factor inputs and prices of factor inputs.
This, is turn, determines for whom to produce. But the demand for factor services depends upon the technique of production.
Thus, in a sense the problem for whom to produce is related to the problem of how to produce. The factors that are in more demand will be paid higher price and vice-versa. Thus, price mechanism decides the problem relating for whom to produce.