The price stops rising or falling at the price where the amount consumers are willing and able to buy is just equal to the amount sellers are willing and able to produce and sell. This is called the market clearing price. Market clearing prices for many goods and services change frequently, for reasons that will be discussed below. But some market prices are stable for long periods of time, such as the prices of candy bars and sodas sold in vending machines, and the prices of pizzas and hamburgers. Most buyers of these products have come to know the general price they will have to pay for these items. Sellers know what prices they can charge, given what consumers will pay and considering the competition they face from other sellers of identical, or very similar, products.

A System of Markets for All Goods and Services

How markets determine price is simple enough to understand for a single good or service in a single location. But consider what happens when there are markets for nearly all of the goods and services produced and consumed in an economy, across the entire country. In that context, this reasonably simple process of setting market prices allows an economic system as large and complex as the U.S. economy to operate with great efficiency and a high degree of freedom for consumers and producers.

Efficiency here means producing what consumers want to buy, at prices that are as low as they can be for producers to stay in business. And it turns out this efficiency is directly linked to the freedom that buyers and sellers have in a market economy. No central authority has to decide how many shirts or cars or sandwiches to produce each day, or where to produce them, or what price to charge for them. Instead, consumers spend their money for the products that give them the most satisfaction, and they try to find the best deal they can in terms of price, quality, convenience, assurances that defective products will be replaced or repaired, or other considerations.

What consumers are willing and able to buy tells producers what they should produce, if they hope to make a profit. Usually consumers have many options to choose from, because more than one producer offers the same or reasonably similar products (such as two or more kinds of cars, colas, and carpets). Producers then compete energetically for the dollars that consumers spend.

Competition among producers determines the best ways to produce a good or service. For example, in the early 1900s automobiles were made largely by hand, one at a time. But once Henry Ford discovered how to lower the cost of producing cars by using assembly lines, other car makers had to adopt the same production methods or be driven out of business (as many were).

Competition also determines what features and quality standards go into products. And competition holds down the costs of production because producers know that consumers compare their prices to the prices charged by other firms and for other products they might buy. In markets where a large number of producers compete, inefficient producers will be driven out of the market.

For example, at one time most towns and cities had independently owned cafes and drive-in restaurants that sold hamburgers, french fries, and soft drinks. Some of these businesses are still operating, but many closed down after larger fast-food chains began opening local franchises all around the nation, with well-known product standards and relatively low prices. The increased competition led to prices that were too low for many of the old cafes and drive-ins to make a profit. The private cafes that did survive were able to meet that level of efficiency, or they managed to make their products different enough from the national chains to keep their customers.

Prices for goods and services can only fall so far, however. Even the most efficient producers have to pay for the natural resources, labor, capital, and entrepreneurship they use to make and sell products. The market price cannot stay below the level of those costs for long without driving all of the producers out of this market. Therefore, if consumers want to buy some good or service not just today but also in the future, they have to pay a price at least high enough to cover the costs of producing it, including enough profit to make it worthwhile for sellers to stay in that market.

Once market prices for various goods and services are set, consumers are free to choose what to buy, and producers are free to choose what to produce and sell. They both follow their self-interest and do what makes them as well off as they can be. When all buyers and sellers do that in an economic system of competitive markets, the overall economy will also be very efficient and responsive to individual preferences.

This economic process is extremely decentralized. For example, it is likely that no one person or government agency knows how many corned beef sandwiches are sold in any large U.S. city on any given day. Individual sellers decide how many sandwiches they are likely to sell and arrange to have enough meat and bread available to meet the demand from their customers.

Consumers usually do not make up their mind about what to eat for lunch or dinner until they walk into the restaurant, grocery store, or sandwich shop. But they know they can go to several different places and choose many different things to eat and drink, while individual sellers know about how much they are likely to sell on an average business day.

Other businesses sell bread and meat and drinks to the restaurants and grocers, but they do not really know how many different sandwiches the different food stores are selling either. They only know how much bread and meat they need to have on hand to satisfy the orders they get from their customers.

Each buyer and seller knows his or her small part of the market very well and makes choices carefully to avoid wasting money and other resources.
When everyone acts this carefully while facing competition from other consumers or producers, the overall system uses its scarce resources very efficiently. Efficiency implies two things here: taking into account the preferences and alternative choices that individual buyers and sellers face, and producing goods and services at the lowest possible cost.

How and Why Market Prices Change

Another advantage of any competitive market system is a high level of flexibility and speed in responding to changing economic conditions. In economies where government agencies and central planners set prices, it often takes much longer to adjust prices to new conditions. In the last decades of the 20th century, the U.S. market economy has made these adjustments very quickly, even compared with other market economies in
Western Europe, Canada, and Japan.

Market prices change whenever something causes a change in demand (the amount people are willing to buy at different prices) or a change in supply (the amount producers are willing and able to make and sell at different prices). see Supply and Demand. Because these changes can occur rapidly, with little or no advance warning, it is important for both consumers and producers to understand what can cause prices to rise and fall. Those who anticipate price changes correctly can often gain financially from their foresight. Those who do not understand why prices have changed are likely to feel bewildered and frustrated, and find it more difficult to know how to respond to changing prices. Market economies are, in fact, sometimes called price systems. It is important to understand why prices rise and fall to understand how a market system works.

Changes in Demand

Demand for most products changes whenever there is a significant change in the level of consumers’ income. In the United States, incomes have risen substantially over the past 200 years. As that happened, the demand for most goods and services also increased. There are, however, a few products that people buy less of as income falls. Examples of these inferior goods include low quality foods and fabrics.

Demand for a product also changes when the price of a substitute product changes. For example, if the price for one brand of blue jeans sharply increases while other brands do not, many consumers will switch to the other brands, so the demand for those brands will increase. Conversely, if the price for beef drops, then many people will buy less pork and chicken.

Some products are complements rather than substitutes. Complements are products that are consumed together, for example cameras and film, or tennis balls and tennis rackets. When the price of a complementary good rises, the demand for a product falls. For example, if the price of cameras rises, the demand for film will fall. On the other hand, if the price of a complementary good falls, the demand for a product will rise.
If the price of tennis rackets falls, for example, more people will buy rackets and the demand for tennis balls will increase.

Demand can also increase or decrease as a product goes in or out of style. When famous athletes or movie stars create a popular new look in clothing or tennis shoes, demand soars. When something goes out of style, it soon disappears from stores, and eventually from people’s closets, too.

If people expect the price of something to go up in the future, they start to buy more of the product now, which increases demand. If they believe the price is going to fall in the future, they wait to buy and hope they were right. Sometimes these choices involve very serious decisions and large amounts of money. For example, people who buy stocks on the stock market are hoping that prices will rise, while at least some of the people selling those stocks expect the prices to fall. But not all economic decisions are this serious. For example, in the 1970s there was a brief episode when toilet paper disappeared from the shelves of grocery stores, because people were afraid that there were going to be shortages and rising prices. It turns out that some of these unfounded fears were based on remarks made by a comedian on a late-night talk show.

The final factor that affects the demand for most goods and services is the number of consumers in the market for a product. In cities where population is rising rapidly, the demand for houses, food, clothing, and entertainment increases dramatically. In areas where population is falling—as it has in many small towns where farm populations are shrinking—demand for these goods and services falls.

Changes in Supply

The supply of most products is also affected by a number of factors. Most important is the cost of producing products. If the price of natural resources, labor, capital, or entrepreneurship rises, sellers will make less profit and will not be as motivated to produce as many units as they were before the cost of production increased. On the other hand, when production costs fall, the amount producers are willing and able to sell increases.

Technological change also affects supply. A new invention or discovery can allow producers to make something that could not be made before. It could also mean that producers can make more of a product using the same or fewer inputs. The most dramatic example of technological change in the
U.S. economy over the past few decades has been in the computer industry.
In the 1990s, small computers that people carry to and from work each day were more powerful and many times less expensive than computers that filled entire rooms just 20 to 30 years earlier.

Opportunities to make profits by producing different goods and services also affect the supply of any individual product. Because many producers are willing to move their resources to completely different markets, profits in one part of the economy can affect the supply of almost any other product. For example, if someone running a barbershop decided to sign a contract to provide and operate the machines that clean runways at a large airport, this would decrease the supply of haircutting services and increase the supply of runway sweeping services.

When suppliers believe the price of the good or service they provide is going to rise in the future, they often wait to sell their product, reducing the current supply of the product. On the other hand, if they believe that the price is going to fall in the future, they try to sell more today, increasing the current supply. We see this behavior by large and small sellers. Examples include individuals who are thinking about selling a house or car, corn and wheat farmers deciding whether to sell or store their crops, and corporations selling manufactured products or reserves of natural resources.

Finally, the number of sellers in a market can also affect the level of supply. Generally, markets with a larger number of sellers are more competitive and have a greater supply of the product to be sold than markets with fewer sellers. But in some cases, the technology of producing a product makes it more efficient to produce large quantities at just a few production sites, or perhaps even at just one. For example, it would not make sense to have two or more water and sewage companies running pipes to every house and business in a city. And automobiles can be produced at a much lower cost in large plants than in small ones, because large plants can take greater advantage of assembly-line production methods.

All these different factors can lead to changes in what consumers demand and what producers supply. As a result, on any given day prices for some things will be rising and those for others will be falling. This creates opportunities for some individuals and firms, and problems for others.
For example, firms producing goods for which the demand and the price are falling may have to lay off workers or even go out of business. But for the economy as a whole, allowing prices to rise and fall quickly in response to changes in any of the market forces that affect supply and demand offers important advantages. It provides an extremely flexible and decentralized system for getting goods and services produced and delivered to households while responding to a vast number of unpredictable changes.

Creative Destruction

Taking advantage of new opportunities while curtailing production of things that are no longer in demand or no longer competitive was described as the process of creative destruction by 20th century Austrian-
American economist Joseph Schumpeter. For example, Schumpeter discussed how the United States, Britain, and other market economies helped many new businesses to grow by building systems of canals (such as the Erie
Canal) during the mid-19th century. But then the canal systems were replaced or “destroyed” by the railroads, which in turn saw their role diminished with the rise of national systems of highways and airports.
The same thing happened in the communications industry in the United
States. The Pony Express, which carried mail between Missouri and
California in the early 1860s, went out of business with the completion of telegraph lines to California. In the 20th century, the telegraph was replaced by the telephone. Time and time again, one decade’s innovation is partially replaced or even destroyed by the next round of technological change.

In the modern world, prices change not only as a result of things that happen in one country, but increasingly because of changes that happen in other countries, too. International change affects production patterns, wages, and jobs in the U.S. economy. Sometimes these changes are triggered by something as simple as weather conditions someplace else in the world that affect the production of grain, coffee, sugar, or other crops. Sometimes it reflects political or financial upheavals in Europe,
Asia, or other parts of the world. There have been several examples of such events in the U.S. economy in the 1990s. Higher coffee prices occurred after poor harvests of coffee beans in South America, and U.S. banks lost large sums of money following financial and political crises in places such as Indonesia and Russia.

The ability to respond quickly to an increasingly volatile economic and political environment is, in many ways, one of the greatest strengths of the U.S. economic system. But these changes can result in hardships for some people or even some large segments of the economy. For example, importing clothing produced in other nations has benefited U.S. consumers by keeping clothing prices lower. In addition, it has been profitable for the firms that import and sell this clothing. However, it has also reduced the number of jobs available in clothing manufacturing for U.S. workers.

Many people think the most important general issue facing the U.S. economy today is how to balance the benefits of quickly adapting to changing economic conditions against the costs of abandoning the old ways. It is vital for the economy to adapt quickly to changing conditions and to focus on producing goods and services that will meet the most recent demands of the market place. However, when businesses close because their products no longer meet the demands of the market, it is important to make retraining or new jobs available to workers who lost their means of making a living.

PRODUCTION OF GOODS AND SERVICES

Before goods and services can be distributed to households and consumed, they must be produced by someone, or by some business or organization. In the United States and other market economies, privately owned firms produce most goods and services using a variety of techniques. One of the most important is specialization, in which different firms make different kinds of products and individual workers perform specific jobs within a company.

Successful firms earn profits for their owners, who accept the risk of losing money if the products the firms try to sell are not purchased by consumers at prices high enough to cover the costs of production. In the modern economy, most firms and workers have found that to be competitive with other firms and workers they must become very good at producing certain kinds of goods and services.

Most businesses in the United States also operate under one of three different legal forms: corporations, partnerships, or sole proprietorships. Each of these forms has certain advantages and disadvantages. Because of that, these three types of business organizations often operate in different kinds of markets. For example, most firms with large amounts of money invested in factories and equipment are organized as corporations.

Specialization and the Division of Labor

In earlier centuries, especially in frontier areas, families in the
United States were much more self-sufficient, producing for themselves most of the goods and services they consumed. But as the U.S. population and economy grew, it became easier for people to buy more and more things in the marketplace. Once that happened, people faced a choice they still face today: In terms of time, money, and other things that they could do, is it less expensive to make something themselves or to let someone else produce it and buy it from them?

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