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Explain how prices play an important role in economic systems.

Before getting to the main answer to this question, we need to note that prices do not play an important role in all economic systems.  Instead, they only play an important role in market economies.  In traditional and command economies, prices are not very important and may not even exist.


In a market economy, however, prices are of supreme importance.  Prices send signals to producers about what they should and should not be making.  Prices...

Before getting to the main answer to this question, we need to note that prices do not play an important role in all economic systems.  Instead, they only play an important role in market economies.  In traditional and command economies, prices are not very important and may not even exist.


In a market economy, however, prices are of supreme importance.  Prices send signals to producers about what they should and should not be making.  Prices send signals to consumers about what they should and should not be buying.  In this way, prices are one of the most important pieces of information in a market system.


In a market economy, how do producers know what to produce?  The government does not tell them.  They could possibly take surveys to ask what they should make, but that would be time-consuming and expensive and it might not even give them good information.  Prices give producers excellent information.  They tell producers how much people are willing to pay for goods and services.  If the price of a certain good is rising, producers know that they should produce more of it.  If the price is falling, they know they should produce less.  Prices tell producers what consumers want, thus giving them the information they need to make good choices about what to produce.


Prices also give consumers information.  Low prices give consumers incentives to buy.  High prices may signal something about the quality of a product.  When prices for a similar good or service are different at different times, this can affect consumer decisions.  For example, if it costs $2 less to go to a matinee movie than an evening movie, more consumers might be motivated to go to the earlier show.  In general, prices help consumers decide which things they will buy.


In these ways, prices are extremely important in market economies.  They do much to help both consumers and producers know how they should behave.  This is why prices can be seen as the “invisible hand” that drives a market economy.

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