Economics for the Curious

Where Do Prices Come From?

How buyers and sellers arrive at prices no one plans

9 min read

Start Here: The Experiment That Surprised Its Author

In the 1950s, a young economist named Vernon Smith doubted the textbook story of supply and demand. He had watched a famous classroom demonstration at Harvard that seemed to show “competitive price theory was an unrealistic idealization of the real world.” So when he began teaching at Purdue, he set up his own test. He reasoned that “if you were going to show that the competitive model did not work,” the test should give the model its best chance, so its failure would be convincing.

In January 1956 he gave each student a private card. Buyers learned only the most they could pay for a unit. Sellers learned only the least they could accept. No one saw anyone else’s card. Then students called out bids and offers and made deals. The result stunned him: “To my amazement the experimental market converged ‘quickly’ to near the predicted equilibrium price and exchange volume, although there were ‘only’ 22 buyers and sellers, none of whom had any information on supply and demand except their own private cost or value.” Smith suspected a fluke and changed the setup. The result held. In 2002 he shared the Nobel Prize for making laboratory experiments a tool of economics.

WATCH Does the Equilibrium Model Work? (Marginal Revolution University)

The Model: Supply, Demand, and Equilibrium

Demand describes how much buyers are willing and able to buy at each price. When a price rises, people buy less: they switch to substitutes, cut back, or go without. That is the law of demand. Supply describes how much sellers are willing and able to offer at each price. A higher price makes it worth producing more, even from costlier sources, so the quantity supplied rises.

The most common mistake is mixing up a move along a curve with a shift of the whole curve. A change in the good’s own price moves buyers along the demand curve: that is a change in quantity demanded. Anything else that changes how much people want at every price shifts the curve: that is a change in demand. The same logic holds for supply.

These are the main forces that shift each curve.

The Model: Supply, Demand, and Equilibrium: Shifter
ShifterCurveExample
IncomeDemandA raise lets a family eat out more often.
Tastes and preferencesDemandA health report makes a food more popular.
Size and makeup of the populationDemandAn aging population wants more health care.
Prices of related goodsDemandPricier beef raises demand for chicken, a substitute. Cheaper printers raise demand for ink, a complement.
ExpectationsDemandWord that prices will jump next month brings buyers in now.
Input and production costsSupplyHigher wages or fuel prices make each unit costlier to produce.
Natural conditionsSupplyA freeze in Florida cuts the orange crop.
TechnologySupplyA better method lowers the cost of producing each unit.
Government policiesSupplyA tax or regulation raises sellers’ costs. A subsidy lowers them.

Equilibrium is the price where the quantity buyers want equals the quantity sellers offer. Above it, there is a surplus: sellers can’t sell all they have, so they cut prices. Below it, there is a shortage: buyers compete for what is available, bid prices up, and give sellers a reason to produce more. Only at equilibrium does that pressure stop. When demand rises, price and quantity both rise. When supply falls, price rises and quantity falls. This is the logic the Price Check readings apply to gas, groceries, housing, college, and health care.

WATCH What Shifts the Demand Curve? and What Shifts the Supply Curve? (Marginal Revolution University)

What Prices Do

Every scarce good gets rationed somehow: by price, by waiting in line, by lottery, by rules, or by connections. In a market economy, prices do most of that work, and no one has to be in charge. They do three jobs at once.

WATCH A Price Is a Signal Wrapped up in an Incentive (Marginal Revolution University)

Another View: The Market as a Process

The model shows where a market ends up. Israel Kirzner, an economist of the Austrian school who taught at New York University for more than forty years, asked how it gets there. In the standard model, the equilibrium price is simply there, as if everyone already knew it. Kirzner argued that in real markets no one does. Tastes, costs, and technology keep changing, no one sees every change, and so prices are always a little wrong. Markets are never fully in equilibrium.

That is where the entrepreneur comes in. For Kirzner, the key trait is alertness: noticing a chance others have missed, such as a good that sells cheaply in one place and is valued more in another. He put it this way: “the function of the entrepreneur consists not of shifting the curves of cost or revenue which face him, but of noticing that they have in fact shifted.” By acting on what they notice, entrepreneurs move prices toward equilibrium. New changes keep arriving, so the market never quite gets there, but the process tends “systematically toward, rather than away from,” equilibrium.

Fair Challenges

  • Prices don’t always adjust quickly. The model assumes prices move until shortages and surpluses disappear. In practice many prices are sticky. A study published by the Federal Reserve Bank of New York found that prices often “remain constant for several weeks and then jump up.” Changing a price has costs, including the work of setting it and “the risk of losing long-term customers when the price increases.” When prices or wages are slow to adjust, a shortage or surplus can last, and unemployment can be one result. The macro readings take this up.
  • Many people think some price increases are unfair. In a well-known 1986 study, Daniel Kahneman, Jack Knetsch, and Richard Thaler asked people about a hardware store that raised the price of snow shovels from $15 to $20 the morning after a snowstorm. Most called it unfair. People accepted price increases that passed on higher costs but objected to raising prices just because demand jumped. Stores that care about their reputations may hold prices down, which helps explain why shelves empty during storms. Whether price-gouging laws help or hurt in an emergency can be tested. Whether profiting from a sudden need is wrong is a question of values.
  • Not every seller takes the market price. The model assumes many buyers and sellers, none big enough to set the price alone. Where one or a few firms dominate, they can. As George Stigler wrote, “When the monopolist raises prices above the competitive level in order to reap his monopoly profits, customers buy less of the product, less is produced, and society as a whole is worse off.” Smith’s own work points the same way: the Nobel committee noted that he “demonstrated the importance of alternative market institutions.” The rules of trading shape how well a market works.
  • Willingness to pay depends on ability to pay. A price gives a scarce good to those willing to pay the most, and income shapes what people can pay. Economist Martin Weitzman showed that whether prices or rationing does better at getting a scarce good to those who need it most depends on the spread of needs and incomes. Prices tend to do better when needs vary widely and incomes are fairly equal. Rationing tends to do better when needs are similar and incomes are unequal. Defenders of prices reply that rationing by lines or rules gives sellers no reason to produce more, so the shortage lasts longer.

Notice what can and can’t be settled by evidence. How sticky prices are, how much market power raises prices, and whether price limits in a disaster shorten or lengthen shortages are empirical questions. Whether it is fair to charge more in an emergency, and whether a good should go to those who pay most, wait longest, or need it most, are questions of values.

What Economics Adds

LISTEN The Economics of Scarcity and the UNC-Duke Basketball Game (with Michael Munger) on EconTalk, hosted by Russ Roberts, with a transcript

The Normative Question

Economics can show how prices ration scarce goods and what happens when they are blocked. It can’t tell you which way of rationing is right. When something is scarce, should it go to those who pay the most, those who wait the longest, those who need it most, or those picked by lottery? Is it fair for a price to rise because demand rose, or only because costs did? Should emergencies follow different rules, and who should decide?

Key Terms in Plain Words

Demand
How much buyers are willing and able to buy at each price.
Supply
How much sellers are willing and able to offer at each price.
Law of demand
When a good’s price rises, people buy less of it, other things equal.
Change in quantity demanded
A move along the demand curve caused by the good’s own price.
Change in demand
A shift of the whole demand curve caused by something other than the good’s price.
Substitutes
Goods used in place of each other, such as beef and chicken.
Complements
Goods used together, such as printers and ink.
Equilibrium
The price where quantity demanded equals quantity supplied.
Shortage
More is wanted than offered at the current price, so buyers bid the price up.
Surplus
More is offered than wanted at the current price, so sellers cut the price.
Sticky prices
Prices that change slowly even when supply or demand shifts.
Entrepreneurial alertness
Kirzner’s term for noticing opportunities others have missed.

Sources