How Prices Get Set

The prices we pay for things can be one of the most emotionally charged day-to-day elements of our lives. We get excited when we can afford something previously out of reach. We get angry and frustrated when things we used to be able to buy now start to feel out reach. We get anxious when prices change quickly--knowing that the world just got more uncertain, and we have less confidence about what we'll be able to afford tomorrow.

We can try to be stoic about it all--but this stuff matters. Our lives are now a series of plans projected out into the future, some short and some very, very long. Life is so complicated already that making good plans is hard enough. Layer in a bunch of uncertainty about something as basic as prices for essentials, and the future rightly starts to look like a chaotic mess.

So let's try to understand a bit more about how prices are set and change.

It's Auctions All the Way Down

The simple answer is: every price is set by auction. Every. Single. One.

That feels intuitively correct when you're live bidding against other buyers--like when you're at an actual auction or buying a house with multiple offers. In other cases, it might be hard to swallow: What about the price of milk at the grocery store? You're not bidding against anyone there.

The "auction" process there is executed over time using the rate of transactions as the key input. If the price of milk posted at the grocery store is too low, then the transactions will happen really fast. The milk will "fly off the shelves" and the store won't be able to keep it in stock.

The proper response--ignoring any government intervention--is to order more milk and raise the price. If the new price of milk is too high, the flow of transactions will slow to a trickle and the milk will spoil, unbought, on the shelves. (If you can't raise the price...well, you do the best you can, but milk will be out of stock often.)

The store will then lower the price until the milk moves as just the right pace. Not too fast, not too slow--maximizing their profit. (Of course, in practice, they have to do this across thousands of items, allocating shelf-space, keeping customers happy with variety, etc. But the principal is the same for each individual item stocked.)

Two-Way Auctions

Once we grasp that every transaction takes place in the context of an auction, the next step is realize it's actually a two-way auction. Let's use housing as an example.

When selling a house, it's easy to see that the buyers are bidding on a house to buy it. If you're a lucky seller, you might get 4 or 5 buyers making offers, and you can go back to them for 1 or 2 rounds to see how far you can push them to bid. The winner of the auction will be the one that values the house most dearly--and therefore is willing to pay the most. It's all very obviously auction-like.

It's harder to see, though, that the seller is actually "bidder" in an auction too. The seller is actually bidding for the buyer's money. If, instead of focusing on a single house being offered to multiple buyers, we think of "bad markets" when there are more houses than buyers, we can see this more clearly.

Imagine it's fall of 2009. The economy is a mess, and the housing market is in the middle of a major crash coming off the excesses earlier in the decade. Instead of one house getting 5 offers, there might be 5 sellers courting a single buyer. It becomes a bit easier to see how the sellers are now bidding on the buyer's money.

The "winner" will the one who values the buyer's money most dearly--and therefore is willing to take the least. It can be harder to "see" the bids here, since there's no direct mechanism for the seller to submit competing bids to the same buyer. But the listing process approximates this buy forcing the sellers to publish their bids for all buyers to see--the asking price.

Over time, as houses fail to sell, the sellers update their bids by adjusting their asking price.

This the same mechanism by which the grocery store "updates the bid" they offer on milk. The price posted is a bid for your money--and when you buy the milk, you accept their bid. Take another look when go through a grocery store, looking at that way, and you can see thousands of items screaming their bids at you for your money. And that's just one store!

1 on 1 Negotiations

What if there's only one buyer and seller? In many cases, it can feel like that– like when you're selling a house and you have only one offer. However, that's not really a 1 on 1 negotiation--both sides can step away and try again with someone else later. It's just an illusion created by time, where we only have one other person to focus on. (And the lack of multiple offers is, in fact, information about the current pricing...)

But what if it's truly a 1 on 1 negotiation. Say you're a specialty vendor, offering a one-of-a-kind service to your only customer, the government. You can still think of this as an auction with exactly one buyer and one seller.

People will use whatever means available to influence the other side's bids--but ultimately, the two sides will continue bidding until a deal is met or one side walks away.

Auctions let you find a price where a transaction can take place, if at all possible. They don't have to end in a transaction, though. Failed auctions tell you that buyers and sellers just can't agree. The fewer buyers and sellers there are, the more likely an auction fails.

Cost, Value and Competition

Nowhere in our discussion did we mention cost or value. The truth is: nobody cares.

Nobody cares what it costs to produce the milk, pay rent at the grocery store, pay employees, or cover spoilage. Nobody cares what it costs to build a house.

In the same way, nobody cares what value is offered too--and we should be thankful for that! Imagine if food or water was priced off the value offered? There'd be no money left for anything else.

The only thing that matters, when setting prices, is how much buyers are willing to pay to and how little sellers are willing to accept.

This is why competition is so important in running a proper economy. Any time there fails to be sufficient competition, one side gains too much power and can often "extract" more value than it should--and that really pisses people off.

Using This

As you look around going forward, keeping this auction framework in mind can help you make good decisions. Ask yourself:

• Are there lots of bidders on both sides or few?
• If few (especially on the other side), what can you do to keep their bids "honest"?
• Is one side more crowded than the other?
• Is the auction happening cleanly, or is one side able to prevent competing bids from entering the market? Can you fight that if its working against you?
• What does your participation look like? Are you desperate to win?
• What can you do (this time or next time) to put yourself on the less crowded side and/or be less desperate to win?