What are the three (3) functions of prices in organizing economic activity? Explain each of these functions.
Freidman believes that the three main functions of prices when dealing with the organization of economic activity are: to transmit information, provide incentive, as well as income distribution.
Freidman uses pencils as his example for how price comes into play with the transmission of information. He states, “The price system transmits only the important information and only to people who need to know.” The adjustment of prices provides information on the supply and demand. Although all parties may not know why, they have the piece of information that they need to know, and that is the cost to them. This works for all parties. As Freidman says, “Prices not only transmit information from buyers to retailers, wholesalers, manufacturers and owners of resources; they also transmit information the other way.”
Price provides incentive by the use of the information. The incentive is what gives prices value and this transmission of information has to be given to the appropriate parties. The incentive of price works by a product being in higher demand, therefore a manufacturer can charge more and those who make the items get paid higher wages. This also gives manufacturers incentive to provide a more efficient product. The incentive would work the same in reverse.
Freidman believes, “The function of prices is intimately connected with the third function-determining the distribution of income-and cannot be explained without brining the function into account.” Now that we understand the incentive for price we can explain how income distribution works as well. Income is distributed by the incentive to work or produce a product whether it be physical or labor. The incentive is provided by profit which comes from the demand of the product. Freidman explains, “Only people have incomes they derive them through the market from the resources they own, whether these be in form of corporate stock, or of bonds, or of land, or of their personal capacity.”