Price signal refers to the information that prices convey to both producers and consumers in a market economy. In particular, prices signal the relative scarcity of different goods in an economy when measured against the competing demands for these goods among consumers. Producers and consumers, in turn, respond to these price signals by modifying their behaviour accordingly. For example, when the price of water is high due to its limited supply in the market, consumers will have a greater incentive to use water more sparingly. Water producers, on the other hand, will have a greater incentive to bring more water into the market; this is because the high price of water offers them an opportunity to earn higher profits.
The flow of goods
Prices in a way thus coordinate the production and distribution of goods and services across the modern economy. This allocation of resources in large economies happens despite the absence of a central planner to direct the allocation. Prices act as market signals that inform possibly millions of people what to produce based on consumer demand. For example, the price of wheat will influence the decisions of millions of farmers whether to cultivate more or less of it during the next farming season. Similarly, the price of wheat will also influence the decisions of millions of households in the country on whether they should increase or cut down their daily wheat consumption. All of this happens spontaneously without any government bureaucracy telling people what to do. The signaling role of prices can also help us predict the likely effects of attempts by governments to manipulate prices. For example, a government might want to make water more affordable during summer and decide to impose a cap on the price of water. This would have a negative impact on the supply of water since the price system in this case is stopped from doing its job of signaling the scarcity of resources. If the price of water is stopped from rising above a certain level by the means of a price cap, this will have two effects. On the one hand, people will have very little reason to use water sparingly as they might if the price of water were allowed to rise to reflect the underlying scarcity of water during summers. On the other hand, when producers are stopped from selling water at a price above the price cap set by the government, they will have less incentive to increase water supply. Both these factors combined could lead to a water shortage wherein the quantity of water demanded is higher than the supply that is available in the market. So, even if consumers were willing to pay the price of water set by the government, the supply to fulfill such demand would not be available.
Some economists have also argued that monetary policy, wherein a central bank regulates the supply of money in the economy, can have adverse effects by compromising the ability of prices to signal properly. They argue that by disturbing price signals, monetary policy can lead to the misallocation of resources. This, they argue, is the reason behind booms and busts in the market economy.
