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Characteristics of the Price System in a Market Economy

Instructor: Sandra Judge

Sandra is a CPA, CA with a graduate diploma in public accounting.

Where do prices come from? In this lesson we will learn where prices come from by examining the four principles of pricing; 1) prices are neutral, 2) prices are market driven, 3) prices are flexible, and 4) prices are efficient.

Characteristics of the Price System in a Market Economy

What are prices? A price is simply the assignment of a numeric value to a product. Prices help us to make everyday economic decisions about our needs are desires. Prices are an indication of the popularity of a product, therefore the more popular the product, the higher the price that can be charged. For example, if you see a table of halter tops for sale you can safely assume that halter tops are not very popular.

Prices are Neutral

Prices are neutral because neither producers nor consumers can impact prices; this means that consumers can buy whatever they want and producers can make and sell whatever they want. Producers offer goods and consumers either say 'yes' or 'no' with dollars. Thus, prices are decided by many interactions between producers and consumers. The market price is the point that the supply and demand curves intersect.

Supply and Demand Curve

Let's use the example of halter tops. If producers make too many halter tops and consumers do not want to buy them, it results in a surplus. A surplus means that quantity is greater than demand. When quantity is greater than demand it causes prices to go down.

Surplus

Otherwise, in a shortage situation (where quantity is less than demand) it causes prices to go up due to scarcity. An example of a shortage situation is housing in New York City.

Shortage

As you can quickly see, in a competitive market neither the producer nor the consumer has any real impact on the price. Therefore, we can safely say that prices are neutral. Examples, where prices are not neutral, would be a monopoly. A monopoly is where only one company can sell a product. A monopoly is not a competitive market; therefore, price neutrality does not apply.

Prices are Market Driven

As previously discussed, producers can make what they want and consumers are free to purchase what they want. This means we live in a market economy.

We will examine some examples; let's look at the supply side (producers). When prices are high, supply increases as many firms join the market. Smartphones are an example when the number of suppliers increased because of high prices. When smartphones were new there were fewer producers in the market and prices were high. The high prices attracted producers to join the market and this caused prices to decrease.

Let's look at the demand side (consumers). When the prices are low, consumers demand and consume more. As prices increase, demand decreases. This is because consumers are rational and try to maximize their happiness for the lowest possible cost. Supply and demand have an inverse relationship. The intersecting point between the supply and demand curve is the market price.

The opposite of a market economy is a planned economy, where investment and production decisions are decided by the government. This leads to inefficiencies due to the high cost of administering the economy. It is more efficient for the market to decide what to produce.

Prices are Flexible

Prices are in a constant state of fluctuation as a result of interactions between sellers, buyers, and the economic environment. This means that prices are flexible. In the past, these fluctuations in prices happened slowly. Today, thanks to the internet, prices fluctuate so quickly that it is easy to observe. Bidding websites are a perfect example of sellers and buyers exchanging information quickly through a competitive bidding process. Since there are so many buyers and sellers, the prices are adjusted rapidly. The bidding process can have either a positive or negative impact on prices.

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