Price is the amount of money for which something can be bought or sold. The price states the worth in money of a unit of a certain good or service. This article discusses how prices are determined and what prices do in free market systems. These systems, in which people carry out their economic activities largely free from government control, operate in the United States and Canada. In planned economies, such as those of Communist nations, the government often determines prices.
How price is determined
Demand and supply.
Prices are based on the economic forces of demand and supply. Demand is the quantity of a good or service that consumers are willing and able to buy. Supply is the quantity producers and other people are willing and able to offer for sale.
Demand usually varies with a product’s price. The lower the price, the greater the demand. This is because people who want the product will buy more of it at a lower price and because the low price will attract new buyers. The tastes and incomes of buyers and potential buyers also determine demand. In addition, demand for one product may be affected by the prices of related products. For example, if an increase in the price of automobiles causes people to buy fewer cars, there will be less demand for automobile tires.
Supply also varies with prices, but in the opposite way from demand. Often, the higher the price, the greater the quantity producers want to supply. But the main determiner of supply is the cost of production, which depends primarily on the costs of labor, materials, and capital. The cost of production may rise or drop as greater quantities are produced, with an associated price change. But this cost and the price may also stay about the same, as greater quantities are produced.
In a free market system, the price of a product tends to settle at an equilibrium price. This is a price at which buyers are able to purchase all they want, and at which sellers are able to sell all they wish to sell. As the conditions of supply and demand change, the equilibrium price moves up or down.
Monopoly.
The price of a product may be affected by special circumstances. For example, a business firm may gain a monopoly–that is, it may control the supply of a product for which there is no close substitute. The firm then may use its monopoly power, or market power, to raise the product’s price. It may raise the price above whatever equilibrium price would have been achieved under competition. Because there are no close substitutes for the product, consumers who want the product will have to pay the high price.
Government intervention
in the market, through price controls or other means, also affects prices. Various price controls may benefit producers or consumers. A price ceiling is a maximum price that is designed to help a certain group of consumers. For example, some city governments put price ceilings on rental units to limit the amount of rent a landlord may charge a tenant. A price floor is a minimum price established by a government. This price is designed to aid certain producers. For example, the U.S. government has established price floors, known as support prices, for many agricultural products in price support programs to help farmers gain profits. The government helps to maintain a support price partly by buying certain quantities of the product and thereby increasing demand.
The government also may use other types of price controls, such as a price freeze. This method holds prices at a certain level, such as the level they were at when the price freeze went into effect.
Although interventions help solve some problems, they may cause others. For example, an effective support price is set above the equilibrium price and a surplus of the product will result. Low prices caused by price ceilings may cause shortages by increasing demand for a product or by decreasing supply.
What prices do
In a free market system, an equilibrium price clears the market–that is, it satisfies buyers and sellers. Price systems thus ration products, distributing them to people willing and able to pay for them.
Prices help determine what goods and services should be produced, how they should be produced, and for whom they should be produced. Consumers let producers know what to produce by indicating the prices they are willing to pay for particular goods and services. Producers decide how to produce goods and services based on the prices of materials and labor. How much people can afford to buy determines for whom goods are produced.
