Today we are going to talk about how market prices are determined. At its most basic, market prices are determined by people acting and as such they do not happen mechanically. Prices are not "just there". They are dynamic and in constant flux, flux that it is determined by people acting with a specific purpose.
Basic Prices
When two people exchange goods or services, they are exchanging goods or services. This may seem obvious. However, for an economist, they are establishing a price for those goods and services that have exchanged. The price so established is the ratio between the exchanged goods or services.
For example, if Patima gives Morin one apple in exchange for five strawberries, then the price of the apple in this transaction is five strawberries. But prices are symmetric. Which means that we can look at the transaction from the other side and say that the price of five strawberries is one apple.
From a Austrian perspective a price is simply the outcome of two people exchanging goods or services, representing their preferences between what they receive and what they give up.
This scenario represents the most basic transaction possible; a direct barter. But the modern marketplace is vastly more complex and we must thus examine it in its complexity.
Modern Markets and Prices
In modern markets barter is almost non-existent. Almost all transactions happen through the utilization of money; this is to say through indirect exchange.
Indirect exchange is not symmetric in terms of goods or services (it is symmetric in terms of transacted items). There is typically only one end of the exchange with a good or service while in the other end there is only money.
Let's take our example from above. Let's say that Patima wants five strawberries and Morin is willing to sell them. Thus a price is agreed whereby Patima gives Morin money and Moring gives Patima five strawberries. In this transaction only five strawberries exist at one end. And the apple? The apple does not enter into the equation because for Patima it was only the means to obtain five strawberries. Instead of giving up the apple, Patime gave up money.
One of the biggest advantages of indirect exchange is that prices are all stated in money instead of other goods and services. Thus, people can perform comparisons between goods and services, comparisons that would have been nearly impossible to achieve otherwise.
This sudden ability to compare apples to strawberries to mice to paint to hard drives (and so on) is what makes economic calculation possible; this is, the ability to estimate our best way to spend our money for whatever purpose we so choose.
As economic beings, we perform economic calculations all the time, whether we even realize it or not. But in order to understand the characteristics of prices in the marketplace, we also need to understand the other actor; the entrepreneur and how this property of money affects their behaviour.
Prices in the Market
In every modern market we can identify two actors: buyers and sellers. We know that we can't classify people into buyers or sellers because we behave as buyers and sellers all the time, depending of the circumstances. But for price analysis, we are going to oversimplify this concept and look at the market as composed by entrepreneurs (sellers) and clients (buyers).
A market originates when there is an unmet demand. At this point an entrepreneur will perform an economic calculation and decide if the price at which he thinks he can sell a good is high enough to cover his expenses and produce profit. If such economic calculation indicates that this is possible, an entrepreneur will enter the market with a good or service. This is the initial step. However, as a market is a dynamic place (i.e. things change all the time), prices tend to change. This is so because buyers also perform economic calculations and decide whether or not they are willing to give up the money asked by the entrepreneur or not.
We must never forget that economic calculations are subjective and personal. There is no such thing as an objective economic calculation. Yes, we can count money and perform accounting operations on money, but the decision whether or not to spend the money in the first place is personal and subjective.
All these processes lead to more-or-less stable prices, although we must be absolutely clear that when we say "stable" we don’t mean fixed. What we mean is that they have little variation over time. Yes. The market by itself leads to stable prices, no government intervention required.
Stable Prices in the Market
But how are stable prices achieved in the market? An entrepreneur offers a product or service at a price at which there are people willing to buy it. But such entrepreneur also needs to be looking at his own supply and demand. If the price is too high, then this entrepreneur will have low total profits (generally speaking - because he is selling just a few units) and a huge inventory (stuff is not selling). Thus, the entrepreneur will lower his prices.
At the other end of the scale, if the price is too low, the entrepreneur will be able to sell all its product for low total profits (the profit per unit sold is low) but he will run out of stock being unable to replenish it because there is insufficient profit. Thus the entrepreneur will raise his prices.
As a consequence of these processes, an entrepreneur will always select a price with the goal of keeping a reasonable stock while maximizing profits. However, as we have seen, if an entrepreneur attempts to move prices in either direction the market itself forces a correction.
In addition, an entrepreneur is seldom alone in a market. An entrepreneur is always competing with other entrepreneurs, whether for similar goods or services or for your money. This is called Catallactic Competition and also forces an entrepreneur to keep prices within a narrow margin.
We can summarize this by saying that the prices of goods and services will operate in a narrow margin because they are limited by the supply on one side (how much can be produced at a profitable level) and the demand on the other (how much are people willing to pay).
This process is enormously facilitated by money, because money makes it possible for people to perform economic calculations which oppose entrepreneurial economic calculations. As such, entrepreneurs are trapped in a narrow margin from which they cannot escape if they want to remain profitable.
As such, the only option entrepreneurs have is to compete to best satisfy the economic calculations of consumers.
Profits
Profits are achieved when prices are low enough to satisfy demands while simultaneously high enough to cover the cost of capital goods. For this reason it is to the advantage of the entrepreneur to lower costs, which means to either find cheaper sources of capital goods or become more efficient thus achieving more with the same capital goods.
Loses
Loses are suffered when the opposite happens. Prices are too high due to increased demand or low supply. But this presents an opportunity for other entrepreneurs to provide more supply to the markets, which will necessarily trigger lower prices. These lower prices will make it impossible for the first entrepreneurs to purchase capital goods and still maintain profitability. Thus, these original entrepreneurs will suffer a loss because the cost of their capital goods will be higher than the (reduced) price at which they are now forced to sell their products.
Note: please see the Glossary if you are unfamiliar with certain words.
