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First, we understand what is Price System?

Price system is an economic organisation of prices and price changes. Each commodity, each service, each factor of production has a price which is indicated in terms of money. These prices serve as signals to consumers and producers both.

Price system works effectively in free market economy wherein consumers and producers enjoy complete economic freedom. The government does not interfere with the decisions and activities of the people in such an economy.

Now, we will discuss how Price system works-

Prices and price changes help balance demand and supply in an individual market. By matching demand and supply in each market, price system solves basic problems of the economy. That is as follows-

1. What to produce and how much: This is decided by the consumers through their purchase decisions. They express their preferences through their money expenditure. If consumers prefer commodity X more than commodity Y, demand for X will increase, while that of Y will decline. Sameway, if price of X will rise while that of Y will fall. Production of X will become more profitable than that of Y. It indicates producers are motivated by the desire to maximise their profits, they will shift resources from Y industry to X industry, so that output of Y will fall and that of X will expand till supply equals demand in both markets. It is how the pattern of total production in economy get adjusted to the pattern of total demand.
2. How to produce: It is determined by the competition among different producers. The way option for producers to meet price competition and maximise profits is to keep costs at a minimum by adopting the most efficient method of production. If in the economy, labour is abundant and capital is short in supply, price of labour will be low as compared to the price of capital. In this situation labour intensive method of production will be less expensive as compared to capital intensive method of production. Here, therefore producers will adopt labour intensive method of production.
3. For whom goods are produced: It depends in large part on the demand and supply in the factor markets. Factor prices like wages, salaries, rent, interest, profits and dividends are determined in factor markets. The distribution of national income among different groups of people in the society is determined both by the quantity of factor services and prices of the factors of production. The persons who own costly factors of production or larger quantities of factors of production will have a large share in national income and output. Same way, on other hand, the persons who own cheap factors of production or small quantities of factors of production will have a small share in national income and output. For eg- the share of industrialists in national income is many times more than that of unskilled workers in our society.
4. Is economy growing continuously: This problem also solved through price system. The impetus for improvement, innovations and development comes through the price system. Higher prices and profits encourage industrial concerns to spend huge sums on research and experimentation to improve and develop techniques of production. The desire for profits motivates entrepreneurs to innovate and when an entrepreneur innovates, profits emerge. It indicates that profits are both a to innovate and when an entrepreneur innovates, profits emerge. It also follows that profits are both a cause and effect of innovations. This indicates, economy grows continuously through inventions and innovations.
5. Are available resources used efficiently or fully: It is also determined by the factor prices in the factor market. For eg- wage rate is freely determined by the market forces of demand and supply and if wage rate is flexible, total demand for labour in the company will be equal to total supply of labour and there will be no unemployment among labourers. If unemployment arises for some reason, wages will fall, demand for labour will expand till it is again equal to supply of labour.

Similarly, if the rate of interest is flexible, total investment in the economy will be equal to total savings. If investment is less than saving, rate of interest will fall, investment will expand till it equals total saving.

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