Now the question arises, in the absence of a central planning authority, who does control and regulate a capitalist economy? In other words who performs the basic functions such as-what, how and for whom to produce? We know that a capitalist economy is a free market economy.
A free market economy uses the impersonal forces of the market to perform its basic functions and to solve its central problems. It means all the central economic problems like what, how and for whom to produce are solved through ‘price mechanism’. Thus it is the price mechanism that makes a capitalist economy to function automatically without central coordinating authority. Market refers to contact and communication between buyers and sellers of goods for the sale and purchases of goods and factor inputs. The buyers bring the demand for goods and factors of production. The sellers, on the other hand, offer supply of goods and factor inputs. Thus, the interaction between the demand and supply forces of various goods or factors of production determines their equilibrium prices. Factor market determines factor prices and commodity market determines commodity prices.
Thus ‘Price Mechanism’ means determination of equilibrium prices in the factor market and production market through the free play of demand and supply forces. The price mechanism brings about equilibrium between demand and supply forces. The price at which demand and supply arc in equilibrium, stay in the market. Any change in demand and supply forces will change the equilibrium prices. The price mechanism directs the producers to decide what, how and for whom to produce. Therefore, the price mechanism is the ‘invisible hand’ which controls and regulates the capitalist economy.
It should be noted that price mechanism assumes that free competition is present in both the factor market and commodity market. Presence of the competition is a necessary condition for the working of price mechanism. The price mechanism or market mechanism works on the principle of self- interest and automatic adjustment.
Prices coordinate the decisions of producers and buyers. Higher prices tend to reduce demand and encourage production. Lower prices increase demand and discourage production. Prices are the balancing forces in the market mechanism. The price mechanism performs the following functions : (i) it provides information’s about consumers’ preferences (ii) it induces the producers to innovate (iii) it influences the decisions to choose technique of production and (iv) it co-ordinates the activities of millions of individuals, households and firms.