The Implications of Market Pricing on Economic Decision-Making

Market Equilibrium
A market reaches market equilibrium when the quantity that consumers are willing and
able to buy matches the quantity that producers are willing and able to sell. In equilibrium,
buyers and sellers’ separate plans are perfectly aligned, and there is no reason to alter. As a
result, market forces impose no more pressure on price or quantity to change.
A Surplus Forces the Price Down
To understand how a particular market reaches equilibrium, we need to consider
demand and supply for the market for pizza as example. What if the price is initially set at
₱120? At that price, producers supply 24 million pizzas per week, but consumers demand only
14 million, resulting in an excess quantity supplied, or a surplus of 10 million pizzas per week.
This surplus means that suppliers are stuck with 10 million pizzas they cannot sell at ₱120.
Suppliers’ desire to eliminate the surplus puts downward pressure on the price.
Producers reduce the quantity supplied as the price declines, while customers increase the
quantity demanded. As long as the quantity supplied exceeds the quantity demanded, the
surplus forces the price to lower.
Market equilibrium occurs at the price at which the quantity demanded by consumers is
equal to the quantity supplied by producers. At prices, above the equilibrium price, the quantity
supplied exceeds the quantity demanded. At these prices, there is a surplus, which puts
downward pressure on the price. At prices below equilibrium, quantity demanded exceeds
quantity supplied. The resulting shortage puts upward pressure on the price.
A market finds equilibrium through the independent and voluntary actions of thousands, or even
millions, of buyers and sellers. In one sense, the market is personal because each consumer
and each producer makes a personal decision about how much to buy or sell at a given price. In
another sense, the market is impersonal because it requires no conscious communication or
coordination among consumers or producers. The price does all the talking. The independent
decisions of many individual buyers or many individual sellers cause the price to reach
equilibrium in competition markets.
Prices reflect relative scarcity. For example, in an airline company seat sale, one-way
flights from Manila to TAcloban are ₱500 more expensive than return flights. Why the
difference? Many more people from Manila want to go to Tacloban than vice-versa.
Market Exchange
To repeat, buyers prefer a lower price and sellers prefer a higher price. Thus, buyers and
sellers have different views about the price of a particular good. Markets help sort out those
differences. Markets answer the questions what to produce, how to produce it, and for whom to
produce it.
Adam Smith’s Invisible Hand
Market prices guide resources to their most productive uses and channel goods to those
consumers who value them the most. Market prices transmit information about relative scarcity
and provide incentives to producers and consumers. Markets also distribute earnings among
resource owners.
The coordination that occurs through markets takes place because of what Adam Smith
called the “invisible hand” or market competition. No individual or small group coordinates
market activities. Rather, it is the voluntary choices of many buyers and sellers responding only
to their individual incentives. Although each individual pursues his or her own self-interest, the
“invisible hand” of competition promotes the general welfare.
Market Exchange is Voluntary
Your experience with competition probably comes from sports and games, where one
side wins and the other loses. Market exchange is not like that. Market exchange is a voluntary
activity in which both sides of the market expect to benefit and usually do. Neither buyers nor
sellers would participate in the market unless they are expected to become better off. A buyer
values the product purchases at least as much as the money paid for it. A seller values the
money received at least as much as the product sold.
For example, a consumer pays ₱90 for a pizza only if he or she expects the marginal
benefit of that pizza to be worth at least the best alternative use of that ₱90. The producer
supplies a pizza for ₱90 only if he or she expects its marginal cost to be no more than P90.
Again, voluntary exchange usually makes both sides better off. Voluntary exchange is typically
win-win.
Role of Prices
Market prices serve as a signal to buyers and sellers about the relative scarcity of the
good. A higher price encourages consumers to find substitutes for good or even go without it. A
higher price also encourages producers to allocate more resources to the production of this
good and fewer resources to the production of other goods.
In short, prices help people recognize market opportunities to make better choices as
consumers as producers. The beneficial effects or market exchange include trade between
people or organizations in different parts of the country, and among people and organizations in
different countries.
Markets Reduce Transaction Costs
A market sorts out the conflicting views of price between demanders and suppliers.
Markets also reduce transaction costs, or the costs of time and information needed to carry
out market exchange. The higher the transaction costs, the less likely it is that an exchange
takes place. For example, the car business needs areas of land so car dealers locate on the
outskirts of town, where land is cheaper. Dealers also tend to locate near each other because,
grouped together, they become a more attractive destination for car buyers. Any dealer who
makes the mistake of locating away from the others will miss out on a lot of business from
comparison shoppers. In this way, car dealers reduce the transaction costs of car shopping.
This is also why stores locate together downtown in suburban malls. More generally, markets
reduce transaction costs.
Factors that impact market price
 Although the principle of market price ultimately depends on supply and demand, there
are number of factors that can also affect market price.
Some things that can affect market price are controllable, while others are out of your
hands. Factors that impact market price include:
• Natural disasters
• World events
• Amount of wages paid to workers
• Decrease or increase in employment
• Pricing of luxury items versus necessities

Natural disasters or other world events (e.g., wars or attacks) can limit supplies to
manufacturers. Decreases in necessary supplies can slow down the production of goods or a
business’s ability to offer services. And if there’s a deficit in products or services, demand can
increase due to limitations.
Employment and the wages paid to workers can also affect the equilibrium price. A
decrease in employment or wages may cause consumers to penny pinch. And, consumers
might not afford to pay the same prices as before. Likewise, an increase in jobs and wages
results in consumers being able to pay more, allowing for higher market prices for goods and
services.
Market prices of luxury items have different equilibriums than basic necessities, like
food. And, luxury products and services break the basic rules of supply and demand. Although
the demand for luxury items is smaller, the prices are almost always high. Rarity does not
impact the price of the luxury item. Instead, consumers are willing to pay more for name brands
and quality.
The price of goods plays a crucial role in determining an efficient distribution of
resources in a market system.

 Price acts as a signal for shortages and surpluses which help firms and
consumers respond to changing market conditions.
 If a good is in shortage – price will tend to rise. Rising prices discourage demand,
and encourage firms to try and increase supply.
 If a good is in surplus – price will tend to fall. Falling price encourage people to
buy, and cause firms to try and cut back on supply.
 Prices help to redistribute resources from goods with little demand to goods and
services which people value more.
 Adam Smith talked about ‘the invisible hand‘ of the market. This ‘invisible hand’
relies on the fluctuation of prices to shift resources to where it is needed.
How price affects consumer behavior
In the short-term, demand is very price inelastic. However, the higher price of oil also
has an effect on consumer behavior in the long-term.

 Consumers look for substitutes or other goods that can replace n the long run.
Therefore, over time, demand falls.
  Over time, people may start recycling or alternative ways to reduce the usage.
 Responding to these changing consumer preferences, firms will develop other
products- enabling more alternatives leads to less demand in long-term.

Limitations of price in the economy

Although the price has an important role in the economy, it has some limitations.

 In the presence of externalities, the price of goods does not reflect the true social
cost / social benefit. Therefore, a free market can cause under or over-
consumption.
 Inequality. Price helps resources shift to areas of greatest demand, but it could
lead to an inequitable distribution of resources. For example, in a draught, the
market price of water could rise so much, people don’t have enough to drink. In
this scenario, it may be more appropriate to introduce a scheme of rationing – to
ensure a fair distribution, rather than efficient distribution.
 Monopoly. In a monopoly, high prices may not reflect shortages, but reflect
monopoly power and this leads to allocative inefficiency.