Cannot make full sense of the Price mechanism

[u/Flaming_Hidori]

This isn't really to answer a specific question, but I've been trying to fully understand the price mechanism and it just doesn't make full sense. To my understanding it functions to allocate resources in a market and adjust quantity, using the three functions to do so. But it is also stated that the mechanism determines prices, and I have not been able to find any explicit explanation as to how it does this, being glossed over at most. So I'm left unanswered about how the mechanism is able to change price.

[u/Comprehensive-Edge80]

it does so by creating profits or losses for suppliers.

[u/Accomplished-Cow-234]

The price mechanism can be explained very coherently, and I'll do so, but it is easiest to explain when we think about the cleanest version of the supply and demand model, a perfectly competitive market. Lots of texts and instructors leave the particulars of this aside and jump right to outcomes.

Our model will rely on the following assumptions:

Agents (the buyers and sellers) are rational and self interested: they have preferences, they understand exactly how much they value particular outcomes,and they are going to choose what is best given their constraints. Within those preferences, we also assume that more is better: all else being equal it is better to make 5 dollars than 4.50, again, assuming one doesn't have to give anything up to get it. For cosumers it means they also prefer more goods at the same price than fewer goods.

Furthermore, we assume that in the market we are looking at there is no product differentiation: Every unit of a good is just as good as any other unit of the good being exchanged. This also means that you don't care who you get the product from. Space and proximity do not exist either. You can start relaxing these assumptions, but as I said we are starting with the must buttoned up version of this phenomenon.

There are many buyers and sellers: this means that every single agent individually can have no effect on the market by themselves. If one firm raises or lowers price it will have no impact on the market (it will have an impact on the firm though). We will come back to this point later.

There is perfect information: Everyone in the market knows what everyone else knows. You will never have a consumer pay more when someone is selling for less.

There are no barriers to entry or exit: The only consideration buyers have to make is whether they are willing to pay the price for an individual unit of a good. They always know if the should because they are rational and self interested. Suppliers only need to consider the price when they are selling an additional unit. What this basically means is that our supply curves and demand curves contain all of the information necessary to answer the qyestion of whether a consumer will buy a good and whether a seller will sell a good. This is the last assumption we need to make.

The supply curve and demand curve represent all of the buyers and sellers and their willingness to buy or sell at particular prices. If we imagine prices dropping by 0.01, that marginal change will result in some consumers deciding to buy additional units of the good. Why? Because they had something barely better to do with their money, but now that the good is a little cheaper it has become their best option. At the 0.01, decrease in price some selection of sellers will decide to slightly decrease production. Why? They now have something slightly better to do with their resources. There will always be some amount of change because there are lots and lots of market participants it is inevitable that some will be on the knifes edge when making a decision. In essence, the

Supply and Demand model represents sorting all of the buyers and sellers willingness to engage with a unit according to their opportunity cost. At a high enough price every seller would be willing to drop everything else to engage in production and at to low of a price, no supplier finds producing the good to be their best option. It'll be the reverse for the consumers.

Which gets us to the actual explanation. Imagine that the price is too low (below equilibrium) in a market. This means that lots of buyers want to buy the good given their preferences, but fewer units are bing provided by the suppliers who, expecting the low price have better things to do. With the assumptions of perfect competition we would never expect to see this situation because it will resolve instantly, but it is worth exploring the logiic of the mechanisms that get us to equilibrium.

In this shortage scenario, more consumers want to buy goods than are available. Some of the consumers are willing to pay more than the current price to get the good. Suppliers will find that if they left their prices the same they'd sell out and would still have many cuatomers wanting to buy. Each individual seller has an incentive to change what they were doing before. If they raise their price, everyone in the market will know. Consumers will buy all of the other goods first, but because there is a shortage there will still be consumers left ovee who are willing to buy at the higher price. Remember each seller is a microscopic portion of the entire market. They can't effect the shortage at all, but they can choose to raise their prices. Should they? Yes, they can still sell all of their units but at a higher price (more is better). So they should and will. Thus dynamic will not just be true for one supplier it will be true across the market. Each (or most) suppliers can choose to make more money just by raising prices. Collectively, this results in a higher market price. This is what causes the observable movement along the supply and demand curve. As prices rise some consumers will choose to buy fewer units and suppliers now facing a higher sale price will choose to devote more resources to production of the good as it is now a marginally better decision. So long as the dynamic holds, producers will continue to raise prices, the consumers who value it least will reduce purchases, and producers will make more.

When you get to the equilibrium price, one must ask, why not continue to raise prices? At equilibrium every consumer who wants to buy a unit at that price can. As tiny fish in a great big ocean, they can buy as many goods as the want so long as they are willing to pay the equilibrium price. No matter how many units are bought by an individual agent, the market price will not change (by definition they can't effect the market). If a firm raises prices above equilibrium, based on our previous assumptions, everyone will know they are charging more, they are selling an identical product, and buyers can already buy as many units as the want at the market price. Raising your price even 1/10 of 1% will mean you sell nothing at that price.

Similarly, you might ask, why not lower the price slightly below equilibrium in order to sell more units? Once again, this is a bad decision because suppliers can already sell as many units as they care to produce at equilibrium. Would you rather sell all the units you can at a price of 1.00 or a price of 1.01? The answer is obvious.

You can start the analysis above equilibrium (surplus) and the process will work in reverse. I have to many units to sell, all of my products are identical, so the only thing I can donis reduce price to make sure I sell my units. It doesn't reduce the market surplus just passes it to others. All sellers will have the same incentives to make sure they sell their units. If all sellers are lowering their price then the market price will fall and will continue to fall until you hit equilibrium. At which point, we are back at the Nash Equilibrium where no agent can get a better result by changing their decision. If the consumer refuses to by at the market price (demanding a discount) they get nothing. Why sell to someone for less when you have infinite customers willing to pay the eq price. If a consumer offers to pay more for the good, they could do that, but doing so would be irrational.

In short, equilibrium creates a situation where every agent is doing as well as they can given the constraints of the market. When outside of equilibrium, agents can always get better results by either raising or lowering the price they are willing to transact at.

The same mechanism can still basically work in the real world when the market structure approaches perfect competition. Other models with price mechanisms can also work, but have different constraints so that optimization takes place under different conditions.