When you go shopping, you almost always know exactly how much something costs before you
buy it.
In fact, we would consider it quite strange if items at a grocery store did not have prices
labeled so that we could decide what to buy.
So how were those prices determined?
In a free-market economy, one which is based exclusively on supply and demand rather than
any kind of government control, prices offer advantages to both consumers and producers.
Prices are an efficient way to allocate or distribute resources.
Prices also work as a language, an incentive, and a signal of economic conditions.
Without prices in the context of a common currency, a seller would have to barter, which
means exchanging one type of good or service for another.
And of course, bartering is not an efficient or convenient way for markets to work.
Both buyers and sellers depend on prices to learn about the supply and demand of a good
or service.
When prices go up, the producer recognizes the chance to make more money and produces
more.
When prices go down, the producer recognizes that the market is too crowded, signaling
that there’s too much of a good or service, and so they had better hold back.
For consumers, on the other hand, when prices go up they are more likely to hold back, but
when prices go down they are more likely to buy, as the good or service carries a low
opportunity cost and maybe even a chance at a good deal.
If supply goes down, but demand stays the same, prices go up.
If supply goes up but demand stays the same, prices go down.
If demand goes up but supply stays the same, prices go up.
And if demand goes down but supply stays the same, prices go down.
So as we can see, prices are both responsive and flexible in order to solve the problems
of too much or too little demand.
Sellers can easily increase prices to solve the problem of a shortage, and just as easily
decrease prices to solve the problem of a surplus.
Ultimately, remember that a consumer wants a high quality good or service and more money
in their pocket, and a producer or seller wants to make money from their good or service.
In other words, they want a profit.
A profit is a financial gain, particularly in reference to the difference between the
amount earned and the cost of buying, operating, or producing something.
In a free market, prices result in more profit because they distribute resources more efficiently.
Efficient resource distribution means that resources will be used for their most valuable
purposes.
It leads to fewer resources being wasted.
Now, there are exceptions to the idea that free markets lead to an efficient distribution
of resources.
One problem is imperfect competition.
If only a few companies are selling something, there might not be enough competition to lower
market prices to the true equilibrium point.
When only two companies dominate a market, it’s called a duopoly.
When only one company dominates a market, it’s called a monopoly.
Whenever a company charges customers too high of a price for goods or services, especially
when demand is high and supplies are limited, it’s called price gouging.
In an uncompetitive market, price gouging is more likely to occur.
A second potential problem with free markets involves negative externalities, which we
will learn about in a later tutorial, but for now these are the unintended negative
side effects of making and selling stuff.
A third problem is the possibility of buyers and sellers not having enough information,
leading them to make poor choices, which are not the most profitable choices possible.
Now with pricing understood, you may also have noticed while shopping that prices for
the same items seem to go up each year.
Why is that?
Let’s move forward and talk
about inflation.