Market price

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Definition

The concept of market price makes sense in the context of markets that are either perfectly competitive or very close to that, because only in such contexts is the price an emergent feature of the market rather than a strategic choice made by a few identifiable individuals.

The market price for a good, also termed its market-clearing price, equilibrium price, or the price at which it clears the market, is the price at which the quantity demanded for the good equals the quantity supplied of the good. The market price of a good depends on all the factors that influence the demand curve for the good as well as all the factors that influence the supply curve for the good.

When the price of a good exceeds the market price, quantity supplied exceeds quantity demanded. This is a situation of excess supply, or surplus. When the price of a good is less than the market price, quantity demanded exceeds quantity supplied. This is a situation of excess demand, or scarcity.

Variations for monopolistic or oligopolistic markets

For a market with only one (monopolistic) seller, the concept of market price can be replaced by the price chosen by that firm. Only part of the analysis of market price, however, applies in such a context, because the choice of price is part of the firm's optimization process and does not arise from market-level intersection of demand and supply curves.

For an oligopolistic market, there are a few sellers, and the determination of price in such a setting is a result of interactions between these sellers that may best be modeled by game theory and depend on the specific beliefs of the sellers about each other.

Graphical determination of market price

The market price of a good is graphically determined as the p-coordinate (the vertical coordinate, or price coordinate) of the intersection of the demand curve and the supply curve. The quantity traded at the price is the q-coordinate (the horizontal coordinate, or quantity coordinate). Below is a pictorial depiction. The dashed horizontal line here represents the value of the market price, also called the equilibrium price.

Marketclearing.png

Market price maximizes social surplus

Producing goods at the market price in the equilibrium quantity maximizes the social surplus -- the sum of the producer surplus and the consumer surplus. Fill this in later

Convergence towards market price

Further information: Convergence towards market price

For the discussion, we assume that sellers are the ones who directly decide both the price and the total quantity produced, and buyers respond by deciding how much to buy. Thus, the situation is asymmetric between buyers and sellers. Thus, sellers are the ones taking action first (by changing price and quantity produced) and buyers respond. (However, none of our conclusions hinge on this asymmetry).

For simplicity, the model also assumes that both buyers and sellers are able to perceive shortages and gluts, and adjust accordingly. In the real world, price fluctuations and increases in demand may be due to inflation, animal spirits, or other factors, and this may lead to inappropriate adjustments. Nonetheless, even in the real world, with deviations from perfect information, non-negligible transaction costs, and not-quite rational behavior, there is a significant tendency to converge towards a market price.

From a higher price

Surplus of magnitude AB occurs above market price

When the price of a good exceeds the market price, supply exceeds demand. This is a situation of excess supply, or surplus. For instance, in the adjacent figure, the surplus is given by the length of the segment AB. A situation of surplus has the following effects:

  • Sellers, seeing unsold inventory, tend to reduce the quantity supplied as well as reduce their price. In other words, they move downward and leftward along the supply curve. (This may typically happen in two ways: sellers cut down their individual production, and some sellers go out of business).
  • As sellers lower their price, buyers become willing to buy more. In other words, buyers move downward and rightward along the demand curve.

This process is expected to continue until the price equals the market price, at which demand equals supply.

From a lower price

Shortfall of magnitude AB occurs below market price

When the price of a good is less than the market price, demand exceeds supply. This is a situation of excess demand, or shortfall, or scarcity. For instance, in the adjacent figure, the shortfall (or scarcity) is the length of the segment AB. A situation of scarcity has the following effects:

  • Sellers, seeing the competition among buyers for the commodity, try to raise price. Simultaneously, seeing the unmet demand, they tend to raise the quantity produced. In other words, they move upward and rightward along the supply curve. (This may typically happen in two ways: existing sellers increase their individual production, and new sellers enter).
  • As sellers increase their price, demand falls. In other words, buyers move upward and leftward along the demand curve.

This process is expected to continue until the price equals the market price, at which demand equals supply.

External changes and comparative statics

The analysis here assumes that the demand curve is downward-sloping, i.e., it assumes the law of demand. It also assumes that the supply curve is upward-sloping, i.e., it assumes the law of supply. For a discussion of other kinds of situations (particularly relevant for long-run supply curves seen in a decreasing cost industry), refer comparative statics for demand and supply#Downward-sloping supply curve.
The analysis here assumes competitive markets. A discussion of the dynamics under other market structures can be found on the page comparative statics for demand and supply.

The demand curve and supply curve, and the subsequent analysis of market price, are all done ceteris paribus all the exogenous parameters (external factors) that influence the demand curve and supply curve. In this section, we study the comparative statics: the influence of changes in these external factors on the equilibrium price.

Changes in the demand curve

When the demand curve expands from the blue to the purple curve, demand increases at the old equilibrium price to A, leading to a shortfall. Price and supply increase till a new equilibrium is attained
When the demand curve contracts from the blue to the purple curve, demand decreases at the old equilibrium price to A, leading to a surplus. Price and supply decrease till a new equilibrium is attained

We have the following basic observations:

  • An outward (or rightward) shift in the demand curve leads to an increase both in the market price and in the equilibrium quantity traded. This increase is achieved by the mechanism discussed above: temporary scarcity is created, suppliers respond by increasing price and production, and buyers respond by reducing their demand from the increased value.
  • An inward (or leftward) shift in the demand curve leads to a decrease both in the market price and in the equilibrium quantity traded. This decrease is achieved by the mechanism discussed above: a surplus is created, suppliers try to get rid of it by reducing quantity produced as well as prices, and buyers respond by increasing their demand from the reduced value.

Note that in certain situations, the demand curve may change shape in a way that is not uniformly inward or outward (for instance, this happens when there are changes in the income distribution over the collection of households being considered).

Here is how the various determinants of demand (typically) influence the demand curve:

  • Income (the income effect): An increase in income typically causes the demand curve to move outward (i.e., more demand at the same price). The exception is for inferior goods.
  • Prices of substitutes (the substitution effect): An increase in the price of substitutes causes the demand curve to move inward, while a decrease in the price of substitutes causes the demand curve to move outward.
  • Prices of complementary goods: An increase in the price of complements typically causes the demand curve to move outward, and a decrease in the price of complements causes the demand curve to move inward.
  • Expectation of future prices: For goods where it is possible to choose when to consume it (hence either hasten or delay gratification), the expectation of lower prices in the future causes an inward shift of the demand curve, and the expectation of high prices in the future causes an outward shift of the demand curve. In contrast, if current consumption is complementary to future consumption, the opposite effect may be encountered.
  • Preferences.

Changes in the supply curve

We have the following basic observations:

  • An outward (or rightward) shift of the supply curve leads to a decrease in the market price and an increase in the equilibrium quantity traded.
  • An inward (or leftward) shift of the supply curve leads to an increase in the market price and a decrease in the equilibrium quantity traded.

A sudden shift in the supply curve is termed a supply shock. Supply shocks for important commodities could have major effects on the economy.

Price-fixing

There are several reasons why the price of a good, service, or commodity may not equal the market price.

Market power and monopoly pricing

Further information: Market power, monopoly pricing

In a perfectly competitive market of the kind needed to achieve the market equilibrium described above, no individual supplier can significantly influence the market price. This is because any supplier who increases price beyond that of others is immediately driven out of the market, while any supplier lowering price to below others is swamped with too much demand. However, in markets where there are few sellers, sellers have market power -- they can control both the price and the quantity they produce. Thus, they can try to maintain price and quantity at a level that maximizes their profit, as opposed to maximizing the social surplus.

The extreme case is monopoly pricing. The monopolist is interested purely in maximizing private profit. This leads the monopolist to typically choose a price greater than the market price, and a quantity less than the equilibrium quantity. The monopolist's main incentive is to restrict supply and keep prices sufficiently high so as to milk the most from buyers with high reservation prices. A solution that maximizes social surplus in a monopoly is the practice of price discrimination, which allows the monopolist to charge different prices to buyers with different reservation prices, with the lowest price range typically being close to what the market price would be.

Regulatory price-fixing

A governmental regulatory body may fix prices in either of two ways:

  • A price ceiling, or a maximum price. If the chosen price ceiling is less than the market price would have been in the absence of a ceiling, then a situation of scarcity or excess demand is created.
  • A price floor, or a minimum price. If the chosen price floor is greater than the market price would have been in the absence of a flor, then a situation of surplus or excess supply is created

Hurdles to convergence

  • The price stickiness phenomenon may create a time lag for prices to adjust to the new equilibrium level when there are changes in demand and supply.
  • In some cases, imperfect information in the hands of buyers and sellers, high transaction costs, and deviations from rational behavior (for instance, adaptive expectations) could be responsible for the price not converging to its equilibrium level. Rather, it may oscillate around the equilibrium level. Even so, it is highly unlikely that the price remains stably to one side of the equilibrium level.
  • Another hurdle to convergence is the fact that since a lot of other factors in the economy are constantly changing, the price does not have enough time to converge. In other words, the demand and supply curves are themselves moving around too fast for the equilibrating tendency on price to play out in full. This is particularly notable when the economy is going through severe supply shocks, hyperinflation, or other changes.