Pricing in Capitalist Economies

08.12.2017 |

Episode #2 of the course Fundamentals of economics by Dr. Michael McDonald


Welcome back!

Yesterday, we explored the concepts of supply and demand, which are crucial to understanding the economic world: Supply tells us how much businesses are willing to produce at a given price for a product, while demand tells us how much consumers will buy at a particular price. Today, we’ll dive deeper in understanding a tension between these two forces in terms of pricing.

The basic principle comprises the following:

• If prices are too high, businesses will produce more than consumers want to buy, creating a surplus of a product.

• If prices are too low, then businesses will not produce enough of a product, which in turn will result in a shortage.

If you look around the world today, it is easy to find examples of products where prices are too high or too low, resulting in shortages or surpluses. One recent example of a surplus is in oil. As prices per barrel for oil rose up to and over $100 a barrel, businesses drilled more and more oil wells. Eventually, so many oil wells were drilled, a high surplus resulted. Because of that surplus, businesses cut the price of the oil they produced, which resulted in prices falling and helped create more buyers. That is common in such circumstances. When businesses have too much of a product because of high prices, they cut the price and consumers buy more.

Shortages are common too. They are usually seen after major natural disasters like hurricanes or when laws prevent businesses from producing. For example, zoning laws often restrict the building of new houses and apartments, which can lead to high housing prices in cities like New York and London. In other cases, governments sometimes impose price caps on certain products, which creates shortages. For instance, Venezuela has imposed price caps on many consumer goods like toilet paper, which in turn has led businesses to decide that they cannot profitably produce the product, leading to a shortage.

In the above situations, consumers compete with one another to find product. If price caps remain in place, the shortage persists and a black market often develops. If the government lifts the price cap or a temporary situation like a hurricane passes, then prices rise and businesses begin producing the product to meet demand, which eliminates the shortage.

In a free market, prices adjust so there is neither a shortage or a surplus. Demand from consumers is balanced by supply from producers. When demand increases, prices increase and businesses supply more. In the modern world, the vast majority of countries operate in this type of free market system, where prices are set by the combination of supply and demand.

Tomorrow, we will talk about individual businesses and how they should set their prices to maximize profits.

Till then!


Recommended book

Economics by Paul Krugman,‎ Robin Wells


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