Prices

Maybe it's change
Or the time of the year
Or is it the way 
That you hold me so near
I swear it's the price of love
--Roger Daltrey

Prices reflect the current exchange rates between trading partners. Prices are usually set in monetary terms. The price of admission to a movie, for example, might be $10.

Without prices, markets could not function. Imagine trying to buy dinner at Chipotle if prices for various entrees were not available.

How are prices determined? In unhampered markets, prices are not set by mandate. Instead, they are determined by discovery. A seller might offer a cell phone model for $500, but if no one buys it, then there is no 'market' at that price. The seller will likely have to lower the phone's price in order to discover where to 'make a market.'

In financial markets, securities are often priced on a 'bid/ask' basis. Consider this recent price quote for Merck & Co (MRK) stock:

Bid: $74.60
Ask: $74.61
Last: $74.60

The 'bid' is the price where marginal buyers currently indicate that they are willing to purchase the security, while the 'ask' price indicates the price where marginal sellers are currently willing to part with the stock. Note that the difference between the bid and ask, also known as the 'spread,' is very narrow--only a penny. When spreads are narrow like this, markets are said to be 'liquid.' In liquid markets, buyers and sellers can do transactions very close to the bid/ask prices. Note that the 'last' price indicated above, i.e., the most recent transaction of MRK stock to be recorded, occurred at $74.60--the same as the current bid price and only a penny less than the ask price.

Liquid markets typically occur when there are lots of buyers and sellers looking to trade. The more buyers and sellers, the narrower the spread. Conversely, when there are few buyers and sellers in a market, spreads typically 'widen.' In housing markets, for instance, one seller and only a couple prospective buyers might result in very wide bid/ask spreads. The seller might offer a house for $300,000 while prospective buyers may only be willing to pay $250,000. Unless the seller is willing to come down in price or the buyer is willing to come up, then the house is likely to remain unpurchased for some time.

Complications arise when prices are set by force rather than through voluntary price discovery. We'll discuss this situation in a subsequent post.

position in MRK