Free Price System

Definition

The term free price system refers to an economic system where prices are decided by exchange of demand and supply and the prices resulting from it is taken as a signal which is communicated between consumers and producers and which helps in guiding production and distribution of the resources. Free price system is also known as free price mechanism and sometimes informally they are called the price mechanism or the price system.

It is with the help of the free price system that supplies are shared, resources are allocated and income is distributed. The free price system or the free price mechanism is very different from the fixed or controlled price system where the decision of fixing price is undertaken by government within a planned economy or a controlled market.

Overview

Unlike in command economy where prices are determined by the state with a fixed price system; the prices in a market economy are determined by free price system which means prices are decided in a decentralized manner by trade which takes place as a result of the prices asked by the producers or sellers matching with the bid prices of the buyers or customers which is the result of subjective value judgment.

Consumers have limited resources at any point of time; they satisfy their wants in a descending hierarchy and bid prices according to the urgency and importance of their various wants. The producers or sellers are communicated about the relative values through price signals. They also have limited resources and so they ask prices accordingly. The market value is established by the interchange of the prices of consumers and producers.

Consumer preference is not constant, so when a good is more preferred by the consumers, the prices rise due to the bidding pressure as the hierarchy of preference of the good is more. Since the price of the good is high, producers employ more productive forces to satisfy the demand of the consumers’ new preference as they find an opportunity to make more profits. When the price is high, producers start producing more of that good, either the existing firms increase production or new firms come up in the market which leads to decrease in price and profit. This lowered price signals the producers to reduce production.

Hence, prices affect demand and supply as well as demand and supply is affected by the prices.