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Russell Roberts

Where Do Prices Come From?

Russell Roberts*

This essay is part of an occasional series on fundamental economic concepts.

 
"Prices adjust. They're not fixed. Supply and demand helps us remember this."
My three sons, ages seven to twelve, suffer from a chronic condition I've heard described by economist John Baden as ironitis—the love of anything made of metal. They are fascinated by cars, trucks, backhoes, tractors and—well, you get the idea. The other day, my middle son suggested that my next car should be a convertible. They're expensive, said his brother and mentioned that the convertible of a particular model was $10,000 more than the more staid version. Why is it more expensive, his brother asked.

A good question. Why are convertibles more expensive than non-convertibles? Why is scotch that's been aged for 21 years more expensive than scotch that's been aged 10? Why are red peppers more expensive than green peppers? Why do Wal-Mart employees earn less than the average worker in the United States? Why is gasoline more expensive in the summer than the winter? Why is gasoline more expensive in Europe than in the United States? Why are roses more expensive on February 14? Why isn't beer more expensive on Super Bowl Sunday? Why are houses in the suburbs of Washington, D.C. more expensive than houses in the suburbs of Richmond, Virginia?

The answers to these questions often turn out to be a little trickier than they first appear. But ignore the answers for now. Just notice that you can ask the questions. There's a certain predictability to prices. An orderliness. It needn't be that way. Prices could be a random jumble, high one day low the next. On some days, movie tickets could cost more than oxford button down shirts, oranges more than a quart of milk. What is the source of that order? Where do prices come from?

The answer at first, seems obvious. The seller sets the price. But if you've ever tried to sell anything, you know that it's not really true. If you want to sell your house, yes, you're free to write whatever number you want on the listing. After all, every house is unique. So you just have to find one person who loves your house, the one who loves the deck you've added or the way you re-did the kitchen or your garden or the hundreds of other things that make a house special. According to this mindset, you can ask a really high price for your house because all you need is one person willing to pay that high price.

But you'll quickly find that if you choose a price that's too high, you won't sell it, even if the person who happens to love your all-purple kitchen happens to walk through the door. That person who loves your house, the one who is willing to pay $500,000, still won't buy it if there's a house that's almost as nice as yours but that's selling for $300,000. As long as the extra value of your house over the alternative to the potential buyer is less than $200,000, you're cooked. Your house won't sell. People don't pay what they're willing to pay unless they have to. When they have choices, they don't have to. Competition protects the buyer. And it protects the seller. You might be willing to sell your house for $100,000. But you won't have to if there are similar houses selling for $300,000.

Sellers and real estate agents understand a house is in competition with other houses, even ones that aren't as nice as yours and even ones that are nicer. So sellers and real estate agents look at the price of "comparables," houses in the same neighborhood with the same number of bedrooms, roughly the same-sized lot, roughly the same square footage of floor space, roughly the same amount of charm, a subjective but real attribute.

But if the price of your house is set by the prices of comparable houses, then what sets the prices of those comparable houses? The whole thing seems circular. The whole thing's a house of cards! What's holding the housing market together?

One answer is that for a particular good of a particular quality—say, a four bedroom house in a leafy suburb of Washington, D.C. in a good school district on a quiet street on a third of an acre—the price adjusts to equate the amount people want to buy with the amount people want to sell.

Prices adjust to equate how much people want to buy with how much they want to sell.

And if people want to buy more than they did before, prices rise. If people want to sell more than they did before, prices fall.

Supply and demand. Buyers are competing with each other. Sellers are competing with each other.

The prices we observe emerge from this competition.

The simple answer of supply and demand is a strange answer, for it presumes you can talk about a good of a particular quality. In the real world, every good has a unique mix of attributes. Even when two goods are physically identical, they almost always come bundled with differing levels of service attached to them.

It's a strange answer for it presumes you can talk about a single price, "the" price of a 100% cotton no-iron button down dress shirt or a comfortable four-door sedan that gets about 25 miles per gallon or that four bedroom house in the suburbs. In the real world, there are multiple prices for the same good. There are bargains. There are sales. Both buyers and sellers make what appear to be mistakes selling for too little or overpaying.

It's a strange answer because people's desires and situations and income and alternatives are constantly changing, so the amount that people want to buy and sell of something can never be pinned down instantaneously. Even if you can talk about "the" price, it's constantly changing.

It's a strange answer because it seems to require lots of information. Otherwise, how could you know how to set the price if you are the seller or whether to pay the price a seller is asking if you are the buyer?

The strangeness of supply and demand leads some to conclude that it only applies to special cases of a homogeneous good where there are a near-infinite number of sellers and where there is perfect information about the quality of the good and the alternatives and their prices. In this view supply and demand might apply to wheat. Maybe.

The alternative view is that supply and demand has to be unrealistic. Otherwise there's no way to make sense of the myriad transactions that are constantly taking place. A realistic portrait of what happens in the Washington, D.C. housing market would have to chronicle the uniqueness of every transaction. That would not only be impossible but uninformative. What is the relationship between all of these transactions?

 

For an introduction to the standard graphs of supply and demand and how to use them, go to Supply and Demand and Applications of Supply and Demand, by Russ Roberts, 2004.

Supply and demand is a way to see the relationship that strips away everything except the fact that what people are willing to pay and what they have to pay depends on the alternatives. Supply and demand is a way to organize our thinking about this peculiar thing economists call markets and competition. Let's put it to work without using a graph and see what we can see.

Both Blades of the Scissors
 

From Principles of Economics, Book VI, Chapter II, by Alfred Marshall, par. VI.II.16:

Thus again we see that demand and supply exert coordinate influences on wages; neither has a claim to predominance; any more than has either blade of a pair of scissors, or either pier of an arch. Wages tend to equal the net product of labour; its marginal productivity rules the demand-price for it; and, on the other side, wages tend to retain a close though indirect and intricate relation with the cost of rearing, training and sustaining the energy of efficient labour. The various elements of the problem mutually determine (in the sense of governing) one another; and incidentally this secures that supply-price and demand-price tend to equality: wages are not governed by demand-price nor by supply-price, but by the whole set of causes which govern demand and supply.

One of the most important virtues of supply and demand is that it forces you to remember what Alfred Marshall called both blades of the scissors. With few exceptions, both buyers and sellers play a role in determining prices. That's surprisingly easy to forget. When my son asked why convertibles are so expensive, his brother explained that people really like them, the demand side of the equation. But that can't be the whole story or even most of it. Surely there are many people in colder rainier climates or even too-hot climates where driving a convertible is unpleasant. So why are they expensive? They're more costly to make because of the mechanism that allows the convertible to retract the roof. Convertibles only exist if their price is greater than non-convertibles. If people liked cars without any kind of roof, they'd be cheaper, not more expensive, than cars with roofs.

A similar logic applies to red and green peppers. Why are red peppers consistently more expensive than green peppers? Why should there be any relationship between the two prices? Green peppers are used in a lot of industrial cooking for their intense flavor. Shouldn't they be more expensive? It turns out that a red pepper is a ripe green pepper. A seller always prefers money today to money tomorrow because money today can be invested in the meanwhile to earn interest. So if green peppers and red peppers sell for the same price, no seller would be willing to supply a red pepper. So red peppers must sell for more. They only exist in the marketplace because some people prefer them to green ones. But if they're going to be available, if sellers are going to be willing to provide them, they're going to have sell for a higher price.

Prices Adjust

Prices adjust. They're not fixed. Supply and demand helps us remember this.

Consider the payroll tax. It's currently structured in the United States to be shared equally between employee and employer. What would happen if all of the tax were paid by the employer? That would seem to benefit employees. But that assumes wages don't change when the legislative burden of the tax changes. But wages are the price of labor. And the price of labor adjusts to equate the amount of labor workers want to sell with the amount that employers want to buy.

Every tax has an impact on both buyers and sellers but the impact isn't described by the legislation. A tax on buyers of labor is going to cause wages to fall. So employees pay part of the tax even if the legislation decrees that half or all of it is on employers. A tax on sellers of cars raises the price of cars. Consumers of cars pay part of the tax in the form of higher prices even if the legislation places all of the tax on the seller.

If legislation were to place the entire payroll tax on employers, then the increased cost to employers would reduce the amount of labor they want to hire. That lowers wages. In fact wages have to fall by the exact reduction in tax to the employees. Similarly, if the tax were to be put entirely on the workers, less labor would be supplied and wages would rise to offset the increase in the tax.

Similarly, increasing taxes on the wealthy does not have the full, intended effect of reducing the gap between the rich and poor. Taxing the wealthy will lead to an increase in wages for high-skilled workers offsetting some or all of the increased tax burden. Mandating benefits for low-wage workers doesn't necessarily achieve the goal of greater equality because the mandated benefits encourage more workers and discourage employers from hiring them. Wages fall, offsetting some or all of the intended increase in well-being the lawmakers and their supporters might have imagined.

Emergence is a different way of seeing

Finally, supply and demand helps us see things in a totally different way. How bizarre it is that partisans credit or blame the president for the average level of wages or inequality in the United States. If wages are rising, the president will brag about all the good jobs the economy is creating. If wages are falling, then the critics of the president fault the president. But the wage level in the United States isn't under the president's control. It's an emergent phenomenon that comes from the choices people make about how much education to get, how many hours to work, and the mix of monetary and non-monetary satisfaction that people choose in various jobs.

The president no more controls wages in the United States than he does the average weight of Americans. He can influence them through various policies that affect the incentives facing workers and employers. But his hand is not on a dial that sets wages any more than he can control how much Americans weigh. As the examples from the previous section show, many of the policies that a president or legislators might propose to improve something, are often offset by market forces.

Available at a price

One of the simplest insights that comes from supply and demand is the availability of goods in the marketplace. When people want more of something, the crowd of more enthusiastic buyers rarely exhausts the supply. Prices adjust to equate how much people want to buy with how much people want to sell. So if people suddenly want more of something, it doesn't just disappear. The price rises inducing an increase in what is available. As Henry George pointed out:

Here is a difference between the animal and the man. Both the jay-hawk and the man eat chickens, but the more jay-hawks the fewer chickens, while the more men the more chickens. Both the seal and the man eat salmon, but when a seal takes a salmon there is a salmon the less, and were seals to increase past a certain point salmon must diminish; while by placing the spawn of the salmon under favorable conditions man can so increase the number of salmon as more than to make up for all he may take, and thus, no matter how much men may increase, their increase need never outrun the supply of salmon. [Progress and Poverty, Book II, Chapter 3, by Henry George, par. II.III.5.]

Because prices can adjust, the shelves are rarely empty in a market economy. As long as you are willing to pay for it, you can have it. Sometimes, you have to pay a little more. Sometimes, a little less, as circumstances changes. But you can find it. That not only makes life easier for those of us who enjoy salmon, it also means that you can specialize and rely on others for much of what you want, knowing that the market will make it available.

A Caveat

Not all prices are set in what the textbooks call perfectly competitive markets. Supply and demand is a poor tool for predicting precisely the exact level of a price. Any individual transaction may deviate from "the" price because of mistakes or emotions. In many markets, an unusually large seller or buyer can affect the market price in significant ways. But just because a market isn't a textbook example of perfect competition doesn't mean supply and demand can't capture enough of the competition that remains. To take an extreme example, the gasoline market in the United States is full of regulations and amounts of market power that exist in various parts of the supply chain. But there is still competition throughout that market, even if it does not conform to the textbook definitions. And price controls, as the supply and demand model predicts, leads to shortages, lines and reductions in quality. That full story is a topic for another time.

Truck, Barter, and Exchange

Adam Smith talked about man's propensity to truck, barter, and exchange. People are always buying and selling stuff. Always looking for a deal. Always looking for a better deal. Always considering the alternatives. The search for a good deal by both buyers and sellers considering alternatives is what economists call competition. The result is that transactions in a market are not independent of one another.

 

From Book I, chapter 2 of Adam Smith's An Inquiry Into the Nature and Causes of the Wealth of Nations, par. I.2.1:

This division of labour, from which so many advantages are derived, is not originally the effect of any human wisdom, which foresees and intends that general opulence to which it gives occasion. It is the necessary, though very slow and gradual, consequence of a certain propensity in human nature which has in view no such extensive utility; the propensity to truck, barter, and exchange one thing for another.

Where do prices come from? The prices that we observe in the world around us emerge from the interaction between buyers and sellers and their alternatives. How can we capture the strange fact that no transaction takes place in a vacuum? How can we capture the order that emerges from all those transactions?

Supply and demand is a simple and powerful way to describe the ways that transactions across time and space are not independent of one another. It is a powerful way to organize our thinking about the complexity that emerges out of the propensity to truck, barter and exchange, a complexity that is the result of human action but not of human design.


* Russell Roberts is a professor of economics at George Mason University and a research fellow at Stanford University's Hoover Institution. He is the Features Editor of the Library of Economics and Liberty and the host of EconTalk.

For more articles by Russell Roberts, see the Archive.
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