• 14Oct

    Why do the prices rise and fall?

    Every product and service has its price that can change under different circumstances occurring on the market. The most important thing about the price of any product is the relation between supply and demand. When they are constantly in the same relation, the price will roughly remain the same and will not change. But if the relation between demand and supply changes in one of two directions, the price will either go up or down, depending on qualitative and quantitative aspects of the change. In every economy there are thousands of products on the market, and, for each of them, different circumstances determine whether the price will rise or fall, but there are two universal laws of the economy that are related to the price.




    Labor theory of value

    The labor theory of value assumes that the price depends on labor time needed to produce the product. There is an interesting story about gold and why it became the most valuable good for exchange in the past and still holds that position today. The answer is simple. It is because it is the rarest metal in the world and is very hard to find. So according to the labor theory of value, it takes the most labor time to locate the gold and to extract it from the mines. We can find supporters of this theory among some of the greatest minds in history: Aristotle, scholastic philosopher Thomas Aquinas, classical economists Adam Smith and David Ricardo, communist philosopher Karl Marx, and Benjamin Franklin – one of the founding fathers of the United States.

    Why do prices rise and fall?

    In every economy there are thousands of products on the market and for each of them different circumstances determine whether the price will rise or fall

    Theory of marginal utility

    The theory of marginal utility is based on subjective preferences of the individuals. According to this theory, the price is derived from its most important utility to a person, so it is entirely based on the priorities. The goods with higher priorities come first, so they will be more exploited in the production, and the more they are being produced the lower their prices will go. Unlike those, the goods with lower priorities will not be exploited as much as the goods with higher priorities – they will be less demanded on the market and their prices will get higher.

    Let’s illustrate that with an example by Eugene von Böhm-Bawerk. In his work, he described a farmer who has five sacks of grain. It turns out that they are not equally valuable to him. The first bag is the most valuable as he is going to use it to make bread and allow him to survive. The second one will be used in similar way – he might make even more bread to have some supplies and be stronger. The third bag might be used to feed the animals on the farm (probably not the animals from the Orwell’s Animal Farm ;)); the fourth one might be used to produce alcohol (well, we all face weakness sometimes); and the fifth one, as suggested by Böhm-Bawerk, will be used to feed the pigeons. Of course the pigeons are least important so if he loses one bag, he will not forego making bread (or alcohol :)) but instead, he is just going to neglect the pigeons. Losing  four bags means eating less while losing three bags doesn’t.

    Finally, we have a combination of the theory of value and the theory of marginal utility. According to this one, the price depends both on the labor time that determines productivity and on the preferences for certain products.

    Today…

    In today’s world, we have very dynamic markets which are regulated by strong competition. The markets are also influenced by various institutions that might impact some variables using their mechanisms (like central banks). For example, one company could use dumping as a weapon against the competition, so it is going to sell the products at the very low price, not to make the profit, but to throw out the competition from the market. This strategy will result in the general fall of prices in certain industries because the competition is also forced to sell the products cheaper to survive on the market. The government uses other mechanisms. It can set low taxes for certain sectors of the economy or give subsidies to stimulate the economy in some areas. These decisions will result in price falling.

    Finally let’s take a look at some examples when the prices go up. These might be:

    • the company’s costs of production goes up;
    • a group of investors retreats from the market; or,
    • for some reason it comes to inflation etc.

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