This is “Why Do Prices Change?”, chapter 7 from the book Theory and Applications of Microeconomics (v. 1.0). For details on it (including licensing), click here.

For more information on the source of this book, or why it is available for free, please see the project's home page. You can browse or download additional books there. You may also download a PDF copy of this book (30 MB) or just this chapter (3 MB), suitable for printing or most e-readers, or a .zip file containing this book's HTML files (for use in a web browser offline).

Has this book helped you? Consider passing it on:
Creative Commons supports free culture from music to education. Their licenses helped make this book available to you.
DonorsChoose.org helps people like you help teachers fund their classroom projects, from art supplies to books to calculators.

Chapter 7 Why Do Prices Change?

Prices in the News

Here are two recent headlines. The first discusses beer prices in England.

Price of a Pint “Could Rise 60%”

The average price of a pint of beer could hit £4 [about $8]…

Scottish & Newcastle today forecast “material price increases” next year. The brewer, which sells three of the top 10 beer brands in Europe including Kronenbourg and Foster’s, is also reviewing its supply chain in a bid to cut costs.

Industry experts say the cost of an average pint will rise by at least 15p, although some are now predicting rises of up to 60%.…

“It is a bleak time for everyone,” said Iain Lowe, research and information manager at Camra [The Campaign for Real Ale]. “These price rises have been predicted for a long time.”Teena Lyons, “The Price of a Pint Could Rise 60%,” Guardian Unlimited, November 20, 2007, accessed January 27, 2011, http://www.guardian.co.uk/business/2007/nov/20/fooddrinks.foodanddrink?gusrc=rss&feed=networkfront.

The second concerns sales of baseball merchandise in Detroit at the start of the 2010 season.

Tigers’ Merchandise Off to Roaring Start

Opening Day is still a day away for Detroit’s baseball fans, but its impending arrival already is generating its share of Detroit Tiger retail hits.

Thousands of fans have flooded Comerica Park’s pro shop and other Metro Detroit sporting outlets in anticipation of Friday afternoon’s home game against the Cleveland Indians, snapping up Tigers jerseys, T-shirts and hats bearing the surnames Cabrera, Verlander and Damon, even Granderson—Tigers old and new.

Though it’s too soon to tell which Tigers will prove most popular at the checkout line, former players have been relegated to the discount bin.

“Retailers take a pretty aggressive stand,” Powell said. Most shops have marked down jerseys and T-shirts branded with ex-Tigers between 25 and 50 percent.

“Granderson and Polanco—we discount the price,” said Brian King, owner of Sports Authentics in Rochester Hills. “Unfortunately, you can’t take the names off the back.”“Tigers’ Merchandise off to Roaring Start,” The Detroit News, April 8, 2010, accessed January 27, 2011, http://www.detnews.com/article/20100408/BIZ/4080349/1129/Tigers-merchandise-off-to-roaring-start.

We could have picked thousands of other examples. If you search Google’s news aggregator on any day with a string such as “an increase in the price of” you will find dozens, perhaps hundreds, of recent news articles that contain this phrase. Our task in this chapter is to see where all these price changes come from and what they imply for other economic variables, such as the quantity of these goods traded.

To see how good you are at this, think about these two stories. Can you explain why the price of beer increased? Can you explain why “Granderson” T-shirts are being sold at discounted prices? What do you think happened to the quantity of beer sold as the price increased? What do you think happened to the quantity of T-shirts sold as the price decreased?

Understanding the sources and consequences of changing prices in the economy is one of the most important tasks of an economist. There is an almost endless list of such analyses in economics. In fact, most of the applications in this textbook ultimately come down to understanding, explaining, and predicting changes in prices. The question that motivates this chapter is so important that we have chosen it as the title:

Why do prices change?

Road Map

All prices in the economy are ultimately chosen by someone. Sometimes they are chosen by marketing or pricing managers in big companies. Sometimes they are chosen by bidders in an auction. Sometimes they are agreed on by the buyer and the seller after bargaining.We discuss these choices in Chapter 5 "eBay and craigslist" and Chapter 6 "Where Do Prices Come From?". Yet we can often make good predictions about prices without looking closely at the individual decision making of buyers and sellers by summarizing their decisions with demand curves and supply curves. Building on the ideas of the individual demand curve and a firm’s supply curve for a good or service, we develop the ideas of supply and demand for an entire market.Individual demand and supply curves are introduced in Chapter 3 "Everyday Decisions" and Chapter 6 "Where Do Prices Come From?". In this chapter, we look at the trade that occurs between firms and households or among different firms in the economy. In the business world, these are called business-to-consumer (B2C) and business-to-business (B2B) trade, respectively. The market demand and supply curves that we derive allow us to predict what will happen to prices and quantities traded when there are changes that influence the market.Chapter 5 "eBay and craigslist" also looks at supply and demand in the context of trade between individuals.

An old joke says that you can ask an economist any question, and he will always give the same answer: supply and demand. Yet—strictly speaking—we are supposed to use the supply-and-demand framework only when we are talking about a competitive market—a market in which a homogeneous good is traded by a large number of buyers and sellers. In practice, economists and others use the framework all the time in settings where these assumptions do not hold. Perhaps surprisingly, this can be a completely reasonable thing to do, and we explain why.

Once we understand why prices change, we consider the implications of these price changes for the functioning of the economy. Prices convey information to both producers and consumers. When the price of a good or a service increases, it encourages consumers to consume less and producers to produce more. As we will see, this means that prices play a crucial role in allocating resources in the economy.

We finish this chapter by looking at three very significant markets in the economy: the labor market, the credit market, and the foreign exchange market. Understanding how these three markets work is necessary for a good understanding of both microeconomics and macroeconomics.