Prices

Exchange ratio for economic goods and services, denominated in terms of a numeraire good called 'money' and determined endogenously as part of a market equilibrium. Prices are terms of trade for exchanging economic goods on markets, like wages as prices for labor duties, interest rates as prices for gain access to future liquidity today, insurance premiums as prices for bearing risk, or option prices as prices for the right to buy or sell at prespecified conditions at a later date.

Prices indicate the 'social' opportunity cost of giving up a marginal unit of goods in exchange for a marginal unit of the numeraire good (money). Thus, they reflect the relative marginal desirability (and costliness) of trading a particular good, as implied by the traders' preferences, technologies, and resources, and hence signal the marginal profitability of supplying and demanding additional units of the good. In particular in a competitive market equilibrium, equilibrium prices are then characterized by the equality of aggregate demand and supply.

Typically, all units of a specified good are traded in a market for the same (uniform) price. Uniform prices leave the market participants some rents from exchanging at fixed terms of trade, thus providing incentives for the voluntary engagement in trade. In competitive environments (see the entry on competitive market equilibrium), the free formation of prices leads to stationary market situations which even maximize the total gains from trade. More generally, equilibrium prices are characterized by the absence of incentives to change aggregate demand and aggregate supply for the particular good in question. Equilibrium prices for derivative financial assets, for example, are determined solely from the principle that no gains from trade are possible (no arbitrage principle); see the entry on option pricing.

Entry by: Jan Vleugels

December 1, 1997
Direct questions and comments to: Glossary master