Understanding the price mechanism and factors affecting price movement in a market economy.

Everything, from groceries and fuel to plane tickets and rent, is more expensive than it once was, especially in recent times. Many people might be left wondering when pricing is going to return to “normal.”

The short answer is that numerous factors contribute to today’s record-high inflation, and there are divergent views on how most of these elements might develop. These factors include post-pandemic consumer demand, ongoing supply chain shortages, geopolitical developments, and the war in Ukraine.

Prices represent what customers are prepared to pay for a product’s value, thus the price is a measure of value. In light of this, prices can fluctuate (up or down) based on factors like supply and demand.

Let’s delve slightly deeper into the basics of how this works and the implications of fluctuating prices from an economic standpoint, starting with the price mechanism.

What is the Price Mechanism?

First of all, the aforementioned concept implies that prices serve an important economic purpose. Prices offer an economic mechanism by which products and services are dispersed among the numerous people who desire them, so long as they are not artificially controlled. Indicators reflecting the strength of the demand for various items, allow companies to adjust their output accordingly.

The price mechanism, which underpins this system, is predicated on the idea that supply and demand for any given good can only be balanced by allowing prices to fluctuate freely.

A surplus of supply will result in low prices and decreased output, which will raise prices until there is a balance between supply and demand. Similarly, if supply is insufficient, prices will be high. This will cause production to expand, which will then cause prices to decrease until supply and demand are balanced.

What are the Economic Principles of Price Movement?

Here are 3 factors that move the price.

#1. Supply and demand

The relationship between supply and demand is described by the economic theory known as the law of supply and demand. A fundamental premise of economics is that when there is a surplus of a good or service relative to the demand, prices will decrease. Prices frequently increase when the supply cannot keep up with the demand.

If supply grows while demand remains constant, prices tend to fall to a lower equilibrium price and a higher equilibrium quantity of products and services.

When the supply of goods and services decreases and the demand remains constant, prices tend to rise to a higher equilibrium price and a smaller amount of products and services are produced.

Supply and demand will fluctuate up and down until an equilibrium price is identified.

Take, for instance, an automaker company overcharging for a new car model. Buyers aren’t willing to spend that much and the company must revise its price to balance supply and demand to reach an equilibrium pricing in which customers are satisfied and supply can resume.

#2. Factors That Affect Prices

Consumers buy a wide range of commodities in the consumer goods space, from necessities like food and clothing to luxuries like gadgets. Employment, wages, price/inflation, interest rates, and consumer confidence are all economic factors that influence demand for consumer products. Higher employment and earnings levels increase consumers’ discretionary income for buying items.

The likelihood that consumers will have additional money to spend decreases as inflation rates rise. Credit purchases become more expensive at higher interest rates, which discourages consumption.

Consumer spending is influenced by consumer confidence as well, with confident consumers more likely to make large purchases. In a free market economy, customers can indirectly instruct producers regarding what goods and services to provide and in what amount through competition for resources, which over time benefits consumers.

#3. Role of Market Forces

In a market economy or an economy with little involvement from the government, market forces are what determine the cost and availability of goods and services.

Prices are driven up by market forces during periods of low supply and high demand, and down by market forces during periods of high supply or low demand. For a good or service, the market is said to have attained equilibrium when supply and demand are equal.

To supply something is to make it available and to provide something that is desired.

Adam Smith’s Invisible Hand

The “invisible hand” of Adam Smith alludes to market dynamics.

Adam Smith, a British political economist and moral philosopher who is sometimes referred to as the father of modern economics, wrote about the “invisible hand” that governs supply and demand, prices for products and services, as well as the creation and distribution of wealth.

This “invisible hand” stood for the forces of supply and demand in the market, which, if left to their own devices, might propel an economy forward. Adam Smith provides a substantial amount of insight into the significance and implications of the free market based on what people want in society and how accessible those wants are in relation to capacity for production.

How or When Might Prices Drop?

To try and figure out when prices might begin to decrease, consider making estimates of important elements, such as when global supply chain issues are likely to be resolved and when the Federal Reserve’s interest rate increases could cause the economy to slow down enough to reduce inflation.

Due to this and the fact that think tanks, research organisations, and economists use a variety of arguments, it is difficult to give a conclusive answer.

Some believe that inflation won’t endure for years and that soon, food and energy prices will level off and the supply chain difficulties will vanish. Inflation will then collapse as fast and drastically as it soared.

Are There Consequences of Price Drops?

Although it may seem like decreasing prices are a good thing, deflation can have a negative impact on the economy, such as when it increases unemployment. It can make a bad situation—such as a recession—even worse—such as with a depression.

Because companies respond to lower profits by reducing costs in order to survive, deflation can result in unemployment. This entails closing shops, factories, and warehouses as well as firing employees.

These employees must then cut back on their own spending, which results in even less demand, more deflation, and a difficult-to-break deflationary spiral.

When an economy is experiencing a crisis, such as a recession or depression, demand for investment and consumption might dry up and a deflationary cycle can start. Both consumers and corporations start to hang onto liquid cash reserves. Saving more money results in spending less money, which further reduces aggregate demand.

Historical Examples of Price Drops

Here are 2 examples in history when prices have dropped below the average.

#1. Great Depression

A consistent drop in the level of prices for goods and services is referred to as deflation. A severe deflationary spiral, in which prices and wages decreased while unemployment increased, was a defining feature of the Great Depression. Combinations of causes, including a decline in consumer demand, excess supply, and a reduction in the money supply, led to the deflation of the Great Depression.

#2. 2008 Financial Crisis

For the first time in decades, house prices started to decline in 2006. Banks accepting mortgages for homeowners with dubious credit, even some for 100% or more of the home’s worth, was one of several causes that contributed to the crisis. Because of the financial system’s deregulation, which allowed banks to invest in derivatives tied to the housing market, the market became unstable.

Ultimately, prices can drop due to their seeming tendency to fluctuate based on the complexities of the market. However, a steep drop in prices does not always indicate a positive movement and can hold some considerably negative implications for the economy. Either way, it’s a good idea to keep track of how price movements affect standards of living.

Conclusion

The price mechanism plays a critical role in distributing products and services in a market economy, and the fluctuation of prices is a natural outcome of supply and demand imbalances. Factors such as supply chain shortages, geopolitical developments, and post-pandemic consumer demand are currently contributing to high inflation rates, but their future impact is uncertain.

Economic principles such as supply and demand, market forces, and the “invisible hand” of Adam Smith provide insights into the factors that affect the movement of prices in a free market. While decreasing prices may seem desirable, deflation can have negative consequences for the economy, such as increasing unemployment. As such, it’s crucial to maintain a balance in the price mechanism to ensure the long-term sustainability of the economy.

 

Interested in learning more about the price mechanism? Let us know in the comments down below.