What Is a Price?

• Author: Irena Asmundson
• Position: Chief Economist of the California Department of Finance.

Back to Basics

At its most basic, a price is the amount of money that a buyer gives to a seller in exchange for a good or a service. When someone hands over $2.00 and receives a pound of tomatoes, the price is straightforward observation: $2.00 a pound. When an actual, observable transaction takes place, the price is sometimes called the traded price or the spot price.

But there are many other types of price. Some of them, such as the marginal price, are conceptual. Others are related to the timing of a potential transaction or to the relative power of the buyer and the seller. All of them, however, ultimately have some relation to the spot price.

Suppose that the tomato transaction takes a slightly different form. The seller might indicate a willingness to sell the tomatoes at a certain price, called the selling price or the ask price. The buyer may make it known that he is willing to pay a different price, which is called the bid price. Such a transaction can occur only if the seller values the tomatoes at $2.00Â a pound or less, and the buyer values the tomatoes at $2.00Â a pound or more. That is, the bid price must be at least as high as the ask price. If it is not, one or both of the parties would be better off keeping what they already had, whether it is tomatoes or money.

Clearing the market

Most of the time, when economists speak of price, they are referring to a market-clearing price—that is, the price at which the amount of a good or service supplied by all sellers in a market is equal to the amount demanded by all buyers. Generally, economists assume that demand decreases as prices rise, and supply increases with price. The point at which these two prices are the same, or intersect, is the market-clearing price (see chart). If a farmer raised prices to a level greater than the market-clearing price on tomatoes, she would not sell them all, and if she lowered prices, she would have to turn away customers because she would run out of tomatoes before the buyers ran out of demand.

But market-clearing prices are not set in stone. Supply and demand can change. For example, if all customers suddenly decided they liked tomatoes more than they used to and were willing to pay a higher price for the same amount, the market-clearing price would rise. It could also rise if the supply of tomatoes declined—because of, say, planting decisions or the weather. The clearing price could also decline with changes in demand or supply.

Many prices

The...