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Explainer: Why prices go up -- and sometimes down

This time of year you're probably doing a lot of shopping and may be finding that some items you were hoping to buy as a gift are out of stock. But most days, people all over the U.S. go to stores to look for goods and services they'd like to buy and, for the most part, these goods and services are supplied by the marketplace in approximately the correct quantities. 

How does this happen?

In a market-based economic system such as ours, prices play a key role in regulating supply and demand and in directing resources in the economy to their best possible use. However, there are instances where prices cannot move far enough or fast enough so that supply and demand are equal. Price floors and price ceilings imposed on an industry limit how far prices can move. Price stickiness limits the speed at which prices can adjust. Here's an explanation of these important terms: 

Price ceilings

A price ceiling is just what the name implies: A maximum price the providers of a good or service are allowed to charge. When this ceiling is below the price needed to equate supply and demand for a good or service, demand will be greater than the supply. Since demand exceeds supply, a rationing mechanism -- first come, first serve or random allocation, for example -- is needed to decide who does and who does not get to consume the good or service.

The best known example of a price ceiling is rent controls. When rent controls are in place, far more people want to live in the low-priced rentals than the available supply provides. If price could increase above the ceiling, it would bring more rental properties to market, and the rise in price would also cause demand to fall, bringing demand and supply into alignment. 

But the constraint on the rents prevents this from happening. Those who are fortunate enough to obtain a rent controlled apartment benefit from the lower rents, but all the people who cannot find a place to live because the price ceiling suppresses supply are out of luck. Thus, there are winners and losers from this type of policy.

Price floors

A price floor is a lower bound for the price of a good, i.e. a minimum price (or wage). Since the price is held above the price that would equate supply and demand, it reduces demand and increases supply creating an excess supply of that particular good or service.

The most prominent example of this is the minimum wage. Theoretically, a minimum wage should produce winners and losers. The winners are those who are employed at a higher wage than they would have received without the minimum, and the losers are all the people who would have been hired if the wage could fall. 

Interestingly, however, this appears to be an instance where increases in the price floor -- an increase in the minimum wage -- does not result in an increase in the excess supply of labor, i.e. an increase in unemployment. Thus, it’s hard to find those who lose from this policy. 

Not everyone agrees with this, it’s possible to find empirical research supporting both sides of this question. But it does appear that an increase in the minimum wage increases the income of those who are employed while having a minimal downside in terms of unemployment (for a nice discussion of this issue, see here).

Another example is farm price supports. In this case, it does appear that maintaining prices above the equilibrium price results in overproduction. The government deals with this excess supply problem in various ways, such as purchasing the excess supply for use in school lunch programs, paying farmers not to produce the good, and the use of quota systems.

Price stickiness

Price floors and price ceilings provide the wrong signals to the marketplace and this results in either an overabundance or shortage of the good or service. This is not the only way prices can send false signals, but it does illustrate the importance of having prices that are flexible enough to equate supply and demand.

One of the key assumptions is the macroeconomics literature is that prices are sticky -- they do not move fast enough to do their job of equating supply and demand. The result is the too much or too little of the goods and services with sticky prices. 

Eventually, the price is reset to correct these imbalances and this causes a slowdown in production. For example, if housing prices are too high there will be too much investment in the industry, i.e. too many houses will be built. Once prices correct, many of the people building and selling houses, providing raw materials to build houses, etc. will need to find employment elsewhere, and this takes time. In the interim, unemployment will be higher and GDP will be lower. 

As you finish up your holiday shopping, you can think about prices you're paying in context of economic theory: In essence, modern macroeconomic models rely upon temporary price ceilings and price floors induced by price stickiness, rather than government decree. These imbalances are the source of fluctuations in economic growth and employment.

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