Market-Clearing Prices

How Are Prices Set and Why Do They Change?

Consumers come to the market to demand specific goods and services—but they are only willing and able to pay so much for those products.

Meanwhile, producers come to the market to supply the goods and services in demand—but they can’t drop their prices too low or they won’t be able to cover costs and make a reasonable profit.

So, what is the price they can both accept? $1? $2? $1.59? How can the consumer and producer agree on a price without spending all day every day arguing over it?

You and millions of consumers like you meet with producers through the market system. Let’s explore what a market is and discover how it helps millions of consumers and producers work together so that both are better off than if they had not entered and exchanged in the marketplace.

See how negotiations between consumers and producers changed over time because of price tags.

Pricing That Works for Everyone

The market-clearing price is the price at which the quantity supplied equals the quantity demanded. This price is the only one that balances, or “clears,” the market.

Market competition tends to move prices toward market-clearing levels. When excess demand exists, it causes buyers to compete more intensely with each other for the amount available. If there isn’t enough of a product for everyone to buy all they want at their preferred price, some people will voluntarily pay more, which pushes the price upward. As the price goes up, two things happen:

1. Some buyers turn away, and quantity demanded drops.

2. Some producers produce more, and quantity supplied increases.

The decrease in quantity demanded and the increase in quantity supplied together push the market toward market equilibrium.

Market Equilibrium

When the price reaches its market-clearing level, the quantity demanded and the quantity supplied are equal. Any excess demand is eliminated; the price rests.

So what happens to the quantity demanded for chicken if the price goes up? Consumers buy less of it at the higher price, right? If the price goes back down, what will consumers do? They’ll buy more at the lower price. This is how a price change affects the amount sold.

Now, predict how poultry farmers will react if chicken prices go up. They will have more income or “revenue,” so they’ll want to produce more while the price is high. Of course, if the price drops, so does revenue. In that case they will want to produce less. This is how a price change affects quantity supplied.

Do you notice a potential conflict?

While a higher price makes producers want to sell more chicken, it makes buyers want to buy less! A lower price makes consumers want to buy more chicken, but it makes producers less willing to supply grocery stores with chicken. It might seem, then, that buyers and sellers won’t be able to agree on either price per pound or the amount of chicken they want to buy and sell. However, in a civil society, there is the art of courteous negotiation.

Learn more about market equilibrium:

Buyers don’t compete against sellers. Buyers compete against other buyers. Sellers compete with other sellers. Think about an auction.

The Intersection of Supply and Demand

Notice that, in the example above, the supply curve and the demand curve for gasoline intersect at $5 per gallon. At that price, the market-clearing price, businesses want to sell and consumers want to buy the same amount of gas per week. The quantity at the market-clearing price is 50 million gallons of gas. This is the only quantity at which every buyer finds a seller and every seller finds a buyer. Economists call this the equilibrium quantity.

Does this price leave everyone in the market satisfied? Of course not. The economy is dynamic. Every individual who wants to buy more gas at lower prices is not satisfied, but they have alternatives, such as taking fewer trips, carpooling, riding the bus, and so on.

Any oil producer who wants to sell oil at a higher price can also consider uses for oil other than gas, such as manufacturing plastic. As long as everyone has choices, the system works, and the market finds a level of activity that fuels itself (no pun intended). The market-clearing price helps direct goods, services, and resources toward their most productive use.

Do markets always operate at the market-clearing price? Sometimes prices are lower or higher than the market-clearing price. However, as long as the negotiations are only between buyers and sellers, prices tend to remain close to or moving toward the market-clearing price at all times.

To understand how a market reaches equilibrium, you need to consider demand and supply.

Excess Demand

Market competition tends to drive prices toward market-clearing levels. Think of concert tickets. Tickets are priced at $40 per seat for a popular artist. The venue has 500 seats to sell, but 900 people want a ticket at that price. That excess demand—more demand than supply—causes a shortage of 400 seats. What do you think will happen? Chances are the concert promoter will raise the price. As the price goes up, fewer people will be willing to buy a ticket. So, the price will begin to move toward the market-clearing price.

Consider the gasoline example. At $3, buyers want to buy 70 million gallons, but producers want to sell only 30 million gallons. The quantity demanded (70) is greater than the quantity supplied (30). In economics, this is called excess demand or a shortage.

Remember, when excess demand exists, buyers compete more intensely for the amount available. Since there isn’t enough gas for everyone to buy all they want at $3 per gallon, some people will voluntarily pay more money for gasoline, which pushes the price upward. Two things result: Some buyers turn away, and quantity demanded drops. And some producers produce more, and quantity supplied increases. Together, the two push the market toward equilibrium.

Every buyer willing and able to buy gas at the market-clearing price can do so. Any seller willing and able to sell gasoline at that price can do the same.

Excess Supply

What happens when a price is higher than the market-clearing price?

Think again of concert tickets. The price has risen to $60 per ticket when the lead singer of the band gets caught on camera saying negative things about the local town. The seller has 500 seats to fill, but now only 300 people want a ticket. That leaves 200 seats without a buyer. The seller is probably going to have to lower the price to get people interested in those tickets.

When the price rises above its market-clearing price, sellers want to sell more units than buyers want to buy. This is called excess supply.

Consider the gasoline example. At $7 per gallon, producers want to sell 70 million gallons per week, but buyers want to buy only 30 million gallons. At that price, quantity supplied is greater than quantity demanded. The difference between the two quantities (40 million gallons) is the surplus.

As with a shortage, a surplus increases competition and drives the market back toward equilibrium. When excess supply exists, sellers begin competing more intensely against one another for consumers’ dollars. Some suppliers will lower prices. As the price begins to fall, two things happen:

1. Some sellers reduce the amount of gasoline they supply. At $7 per gallon, for instance, suppliers want to sell 70 million gallons instead of the 80 million gallons they offered when the price was $8.

2. Some buyers increase the amount of gasoline they want to buy. At $7 per gallon, buyers as a group want to buy 30 million gallons per week instead of the 20 million gallons they wanted at $8.

Government Influence on the Market-Clearing Price

Many consumers and producers have been financially affected by the COVID-19 crisis: producers have surpluses, consumers have lost jobs, schoolchildren have lost the meals previously provided in school cafeterias. With so many affected by the crisis, people naturally look to the government for help.

Government leaders generally recognize the value of the free market. But sometimes the government intervenes in the market. The government may decide that something is unhealthy for citizens and tax it to discourage buyers. Or the government may step in if it determines that a product or service is so vital that everyone should be able to access it at a low cost. In some situations, when people are asking for help, many policymakers believe that whatever is lost in the free market exchange is worth the benefits they hope to gain.

Just like consumers and producers, government policymakers can influence prices and production. Consumers and producers use negotiation within the market to agree on pricing and quantity. Meanwhile, the government influences the market externally by setting policies that change the negotiations between buyers and sellers.

The government has tremendous influence on demand, supply, prices, resources, and production at national, state, and even local levels. What happens when governments choose to use the political process to influence prices and production in the market?

Price Controls

Why would the government want to influence the negotiation between buyers and sellers? Sometimes groups of buyers or sellers have a particular issue that they believe requires the government to intervene in the regular market negotiations. They often have good intentions for asking the government to impose price controls that determine how high or how low prices can go. Economic reasoning helps evaluate whether the benefits outweigh the costs.

Explore price controls and their common results:

Price Floors

A price floor establishes the minimum price that can legally be charged. When a price floor is imposed above the current market-clearing price, it influences the market for both buyers and sellers.

Let’s say that scientists have developed a magic bean. It makes you healthy and happy. However, it is expensive and difficult to grow. And profit margins are low, so few producers choose to grow it. This situation prompts the magic bean farmers (producers) to approach government officials to complain.

“If we could get a little help, we could grow more beans and everyone would be happy and healthy,” they say.

This sounds good and fair to the officials, so they pass a law setting a high minimum price. At last, the farmers will get enough profit that they can make more magic beans, right?

But wait. You can figure out what happens next. When a price is higher than the market would normally bear, there is more potential for profit, but what actually happens to the amount purchased? Consumers decide it’s cheaper to be happy and healthy some other way; they won’t buy the beans at the inflated price. In the end, the bean farmers may actually make less on the magic beans because they tried to interfere with courteous market negotiations.

Most economists think price floors are not rooted in sound economic reasoning. Although they may lead to one positive intended consequence, there are usually unintended consequences when price signals are distorted.

Consider the magic bean example. Magic bean farmers wanted a higher price so they would get more profit. For a little while, they sold a few beans at the higher price and things looked good. The farmers grew more magic beans. Wasn’t that the point? They had promised enough for everyone if the government helped them out.

Then, stockpiles of magic beans grew because buyers chose less expensive substitute products. The price floor created a surplus, or excess supply. None of this was what the bean farmers meant to happen. They thought they could bend the market in their favor by convincing well-meaning policymakers in the government to act on their behalf.

When analyzing price controls, it is important to consider these unintended, secondary effects.

Price Ceilings

Let’s look at another price control. A price ceiling establishes a maximum price that can be charged for a good, service, or resource. The government usually imposes a price ceiling with the intent of helping people who face relatively high prices. Here’s a common example: Rent controls are set with the promise of making housing affordable. Is that possible? Let’s see.

Learn more about rent control, an example of a price ceiling:

Let’s assume that the government imposes a price ceiling of $600 per month on apartment rental units. The intended consequence is to get those who need it into affordable housing. Sounds pretty good, right?

If the price ceiling is set below the market-clearing price, we need to look at what happens to the number of housing units supplied at the rent-controlled price and compare that with the number of units demanded. If the rent is less than the market-clearing price, the quantity demanded will be greater than quantity supplied. A shortage will emerge.

Channel your inner economist to answer this question: Examine the relationship between the price ceiling of $600 and the market-clearing price. Which is higher?

The market-clearing price is about $1,100 per apartment and promises to house about 55 families (that is, 55 housing units). At the below-equilibrium price of $600 (now required by law), the number of apartments demanded is more than the number of apartments owners supply. Although 80 families want an apartment at that rental price, only 30 families get one. This shortage is the unintended consequence of the price ceiling.

Another common, unintended consequence of a price ceiling is that the quality of the property will likely deteriorate since the landlord will have less income. At the monthly rental price of $1,100, apartment owners can cover their production costs, such as paying taxes and maintaining the building. But the price ceiling prevents them from paying their own bills. Fewer amenities such as pools, gyms, or common areas will be offered. The sellers have no incentive or reasonable profit margin to afford these extras.

If not for the price ceiling, the rental rate would rise, providing producers (apartment owners) with a greater incentive to supply more and consumers (renters) with more incentive to find other housing options. These forces would eliminate the shortage.

Summary

Producers and consumers alike help each other by buying and selling through courteous negotiations in markets. Consumers determine the amounts demanded, and producers determine the amounts supplied. The point at which consumers and producers meet establishes the market-clearing price and creates equilibrium.

Price controls are intended to help targeted groups through government interventions. These groups believe their need justifies bending the market negotiations in their favor. But while price controls often have positive, intended consequences, they also have negative, unintended consequences which should always be considered.