People exchange only if each party values what they receive more than what they give away. The price is the exchange ratio between the traded goods: if Alice trades Bob 4 apples for an orange, the price of an orange is 4 apples. Inversely, the price of an apple is 1/4 oranges. The exchange ratios are now, as a rule, money prices.
A market price refers to the special conditions of a concrete act of exchange (of two individuals, that exchanged definite quantities of two definite goods at a definite place and at a definite date). In the end, it is determined by value judgments of the individuals involved.
A market price is not derived from the general price structure or from the structure of the prices of a special class of commodities or services. What is called the price structure is an abstract notion derived from the many individual concrete prices. The market does not generate prices of land or motorcars in general nor wage rates in general, but prices for a certain piece of land or a certain car and wage rates for a performance of a certain kind. Things are valued based on their power to remove uneasiness.
Prices as information
In a market economy, prices are not arbitrary, but signal real, underlying scarcity and help everyone in the economy adjust his plans in light of reality.
This includes interest rates on various loans. In particular, the market interest rate coordinates the "intertemporal" (i.e., across-time) activities of investors, businesses, and consumers. If consumers become more future-oriented and want to reduce consumption in the near term in order to provide more for later years, what happens in the free market is that the increased savings push down interest rates, which then signal entrepreneurs to borrow more and invest in longer projects. Thus resources (such as labor, oil, steel, and machine time) get redirected away from present goods, like TVs and sports cars, and the freed-up resources flow into capital or investment goods like tractors and cargo ships.
If the interest rates are artificially reduced below their free-market level, it sends a false message to entrepreneurs. Firms begin expanding as if consumers have increased their savings, but in fact, consumers have reduced their savings (due to the lower interest rates). Businesses that churn out durable goods, such as furnaces, cargo ships, and houses will find business booming because these sectors respond positively to low-interest rates.
In a barter society, prices are established on the innumerable markets of one good for every other good. With the establishment of a money economy, the number of markets needed is immeasurably reduced. A large variety of goods exchange against the money commodity, and the money commodity exchanges for a large variety of goods. Every single market, then (with the exception of isolated instances of barter) includes the money commodity as one of the two elements.
With money used for all exchanges, money prices serve as a common denominator of all exchange ratios. If, for example, one horse exchanges for five ounces of gold and one barrel of fish exchanges for 1/20 ounces, then one horse can be indirectly exchanged for 100 barrels of fish. It must be emphasized that these exchange ratios are only hypothetical, and can be computed at all only because of the exchanges against money. It is only through the use of money that we can hypothetically estimate these "barter ratios," and it is only by intermediate exchanges against money that one good can finally be exchanged for the other at this hypothetical ratio.
In the market, there will always be a tendency for one money price to be established for each good. If the "ruling" market price for 100 barrels of fish, for example, is five ounces—i.e., if sellers and buyers believe that they can sell and buy the fish they desire for five ounces per 100 barrels—then no buyer will pay six ounces, and no seller will accept four ounces for the fish.
The purchasing power of a stock of any good is equal to the amount of money it can "buy" on the market and is therefore directly determined by the money price that it can obtain. In turn, the purchasing power of a unit of money consists of an array of all the particular goods-prices in the society in terms of the unit.
Formation of prices
Prices are set by the producers. It is in their interest to secure a price where the produced quantity can be sold at a profit. In setting this price, the producer/entrepreneur has to consider how much money consumers are likely to spend on the supply of his product, the prices of various competitive products, and the cost of production.
Producers set the price, but they are at complete mercy of the consumers, their buying or not buying decides, whether a price will lead to profit.
If at a set price, a producer cannot make a profit because not enough people are willing to buy his product, he will be forced to lower the price to boost turnover (and may also need to adjust his costs to make a profit). Profit is an indication that both producers and consumers have improved their well-being.
When a good makes a profit at a particular price, then it is a signal to entrepreneurs that consumers are willing to support the product at the set price. Prices, therefore, are an important factor in establishing how producers employ their resources.
- Main article: Price controls
Over the course of history, governments tried many times to regulate prices in some manner, either to set them directly or by setting minimum and maximum prices.
Price controls rarely succeed even for a short time and have a long record of failing in the long term, with many adverse consequences.
- Ludwig von Mises. "1. The Pricing Process", Human Action, online edition, Chapter XVI. Prices, Mises Institute. Referenced 2009-05-11}.
- Murray N. Rothbard "4. Terms of Exchange" Chapter 2 - Direct exchange, Man, Economy and State, online edition, referenced 2009-05-05. "The price of a good in terms of another is the amount of the other good divided by the amount of the first good in the exchange."
- Ludwig von Mises. "13. Prices and Income", Human Action, online edition, Chapter XVI. Prices, Mises Institute. Referenced 2009-05-11}.
- Robert P. Murphy. "Austrians Can Explain the Boom and the Bust", Mises Daily, March 2009, referenced 2010-04-27.
- Frank Shostak. "The Limits of Supply and Demand", Mises Institute, posted on 2002-09-04, referenced 2009-05-14.
- Robert L. Schuettinger and Eamonn F. Butler. "Forty Centuries of Wage and Price Controls", Chapter 19 - The Economic Effects Of Wage and Price Controls, p. 139-145, referenced 2009-09-11.