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LeoGlossary: Price

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leoglossary
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Price is one of those concepts that can have different meanings especially in relation to economics and accounting.

The most straightforward idea is that it is point where a buyer and seller agree to make an exchange. A merchant tends to have an idea of what they need to sell a good or service for while the buyer has an opinion of what to pay.

This translates into the money (or payment made) in exchange for the product or service.

Market Clearing Price

When economists refer to price they are talking about the market clearing point. This is the equilibrium where all the sellers meet the demand of the buyers.

Economists assume that demand decreases as prices rise, and supply increases with price. The intersection is the market clearing price.

One challenge is theory does not always capture reality. There are many variables that enter into the equation such as a change in either supply and demand. This can happen for reasons outside of price. Customer preference can change which affect demand in ways not present before. This would alter the market clearing price.

Price Versus Value

Warren Buffett is noted for saying "price is what you pay, value is what you receive".

A price is a meeting of value, at least in the mind of the parties involved in the transaction. Value is a subjective term that is often hard to quantify. Price is always a quantified metric.

Markets can move prices higher while value might not change. There are times when prices get out of control, far exceeding what rational people be willing to pay. If this is widespread, the market is said to be in a bubble.

This can apply to assets such as stocks, collectibles, or real estate.

Since value is not always quantified, price will often exceed it when other factors enter. For example, someone might be willing to overpay for something because it has sentimental value. This is not going to be reflected in the pricing mechanism of supply and demand yet will affect the market clearing price.

Price Stability

Central banks along with economists often talk about price stability. This is something that is a core part of monetary policy.

An economy is not well served if prices are making large moves in either direction. Merchants depends upon price stability in order to run their businesses. If the cost of goods, labor, or other necessary components are volatile, commerce becomes difficult. Profit margins are difficult if the costs are moving at a pace faster than the market can absorb them.

The Federal Reserve as price stability as one of its mandates. The adjustment of interest rates are believed to have an impact on prices. Monetary policy is just one factor that goes into pricing which can cause instability in spite of the actions of a monetary authority.

Normal business cycles tend to affect prices, regardless of the monetary system. This tends to reflect human nature whereby excess tends to result during the move towards the peak. Once that is hit, prices will drop as the cycle reverses, heading towards the trough. It is at that point that markets bottom and prices start to increase as economic expansion occurs.

Since the US dollar is the reserve currency, the Fed has an added interest in maintaining price stability. Those who believe in central bank power will claim the Fed's actions directly impact the global economy.

Others will take the approach that much of the dollar's price stability comes from the amount of economic productivity tied to it and the number of people who utilize it.

Other Currencies

Exchange rates have a large impact upon purchasing power when looking at the international situation.

When the USD is strong, it can have a devastating effect on the economies of other nations, especially those the developing countries. A strong dollar will make the local currency worth less, a problem when purchasing goods that are priced in USD. Since most commodities are transacted in dollars, the net result for those economies are rising prices even if the goods are static in USD.

The reverse can also be true. A weaker dollar can often aid those economies as it increases the purchasing power of the local currency on items prices in USD.

Monopolies And Prices

Monopolies do not operate according to free market mechanisms. They are a skewing of the supply and demand dynamics to the point where control is in the hand of one entity.

Under these circumstances, governments will step in. There are examples of legalized monopolies such as utility companies who are regulated by government entities. In these instances, governments have a hand in the prices that are charged.

We also see monopolies form through consolidation in an industry. Governments will often step in to break up the monopoly or have it sell off some parts if it presents a threat to the price dynamic deemed unacceptable to those agencies.

Price versus Cost

These two terms tend to be used interchangeably yet they have different meanings.

Price is what a merchant will offer a good or service to a buy. This is what someone is will to buy something for. It could be an individual or business doing the buying.

The cost is what is into the product. This usually refers to the merchant, manufacturers, or seller.

So the price of a car might be $25,000 yet the cost, to the dealership, is $21,000.

Inflation and deflation

Many use the term "inflation" to mean price increases. This is technically not accurate, at least according to traditional definitions.

Inflation is the expansion of the money supply. By definition, deflation much be a contraction. Neither of these have anything to do with prices although they can have an impact.

There are cases where the expansion of the money supply did result in prices increasing. The Great Inflation of the 1970s is one such example. Even though it can be present, there are no guarantees.

Supply chain disruptions can also have an impact upon prices. This can send prices higher without any additional money being created. Under this situation, inflation is not present. Instead, we are simply dealing with price increases.

Technology

Technology is another variable that can affect prices. By its nature, this tends to have "deflationary" effect upon prices (i.e. it sends them down). Over time, as technology advances, we see the prices for many goods and services go down. The Internet disrupted many industries as it sent the prices down towards zero.

For example, during the 1980s, stock purchases would cost $50 or $100 and done through a phone order to someone at the brokerage firm. The Internet brought the idea of buying these assets through a website or application, eventually driving the fees down to zero.

The digital world is rapidly advancing due to computation following Moore's Law. It is less expensive to operate in this manner as opposed to the physical world.

Prices are going to be affected as more industries become digitized.

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