Price signalling
Resource allocation - the importance of price as a signal
Signalling function
In a market economy, prices perform a signalling function - prices adjust to show where resources are required and where they are not.
Incentive function
Prices also perform an incentive function. As prices rise or fall, this provides an incentive for producers to increase/reduce supply (as profitability of the good changes) and an incentive for consumers to purchase less/more (as the benefit they receive falls/rises).
The central problem of economics is one of scarcity of productive resources relative to the unlimited potential demand that could be made upon them. It therefore follows that every society, be it centrally planned or based upon markets, has to have some mechanism (system) by which its resources, that is its land, labour and capital, are allocated amongst all the numerous uses to which they could be put. So, by what process are resources deployed so as to ensure that consumers obtain exactly the right amounts of frying pans, ice creams, jeans etc. that they require? Well, under a system of central planning the answer is not too difficult to ascertain - the state planning authority decides upon its priorities and directs resources to those lines of production which are deemed to be most important; but, in the absence of a central planning authority, how do consumers magically obtain those goods that they want in just the right quantities? Here the answer is slightly less obvious - essentially, it is through the interaction of demand and supply. How exactly does this interaction perform the allocative function?
The short answer to the above question is that it is through movements in prices. These changes in price indicate and motivate - this is called the signalling function. Changes in price indicate the relative strength of consumer demand and signal to producers the changes in demand for their goods or services. Prices also indicate changes in supply that enable producers to signal to consumers what is available on the market and on what terms. Rising prices of goods motivate producers to respond to increases in demand by increasing supply; producers will decrease supply when prices fall. You will see more clearly how this works when you see how the market forces of supply and demand interact to determine price.
