What is the Market Price?

The market price is like stepping on the scale…

When you want to know what you weigh today, you need a new measurement. What you weighed yesterday is probably a reasonable estimate, but you’ve eaten and burned calories since then. The only way to know where your weight is today is to get a new reading. Similarly, the market price tells you what something's worth right now. It fluctuates as things change.

The market price is the amount of money a buyer gives a seller for a product. It’s the price that occurs in the open market — where many buyers and sellers compete with one another. In a free-market economy, the market decides the market price. It’s not a guess by an analyst or a sweetheart deal between friends. Instead, it’s the actual price that results in a trade.

In economics, normal price refers to the point at which a market balances (the market equilibrium) if there were perfect competition. It is the price toward which the market should gravitate if there are enough sellers and nothing changes with supply and demand.

For example, if a grocery store puts too high a price on bananas, then the customers won’t buy them. In response, the store manager will reduce the price. Likewise, if the price were set too low, they'd sell out quickly. That’s a signal to the manager that they can increase the price. In theory, there's some price between being too low and too high that is just right. That’s the normal price.

While the normal price always exists below the surface, the market price is visible to anyone watching. The market price is what people actually pay for something. But market prices change all the time. Restaurants change the price on their menus; car dealers negotiate different prices for each buyer; stock traders buy and sell shares at different values all day long. Those market transactions represent the market price, which fluctuates over time.

Meanwhile, there’s a normal price that represents the forces of supply and demand that guides buyers and sellers. The normal price doesn’t change unless something shifts the supply or demand curve.

Current market price is often a legal term used in contracts. The contract will typically specify how the current market price is to be calculated. For example, the current market price of an acquisition might mean the average of the closing price during the 20 trading days before the contract date. In the more general sense, the current market price might merely refer to the sales price of the most recent transaction.

In financial markets, stocks, bonds, and other securities trade several times a day. So, the market price is constantly changing. Someone might want to specify the current market price, also known as the current price, as opposed to the opening price or the price at some other previous time. In this context, the current market price is the same as the market value (what an owner would receive if they sold their interests) of a security.

Generally speaking, the market price is the price determined by market forces. The law of supply says that suppliers will be more willing to sell a product as the price rises. The law of demand says that consumers will be more willing to buy a product as the price falls. These two economic laws interact in the market to determine the market clearing price at which the number of buyers and sellers are balanced. The price and quantity combination that balances the forces of supply and demand is called the market equilibrium.

Of course, the market price and the equilibrium price don't always line up. The equilibrium price is the theoretical market price, but the market isn't always perfect. Sometimes emotions and bad information make the market price move away from the equilibrium for a time. But economic theory says that those mistakes should correct themselves over time.

Technically, the market decides the market price — You don’t really calculate it. But the market price should theoretically converge on the market clearing price. That price happens at the market equilibrium (the intersection point of a supply curve and a demand curve), which is something you can calculate with a bit of algebra.

Supply curves represent the marginal cost of production, which is the amount it costs to produce each additional unit. The law of supply says that the marginal cost of production tends to increase as production increases. That is because businesses try to maximize profits by exhausting their lowest-cost options first. So, increasing production requires using higher cost materials. Supply curves typically take the form of an equation where:

Price = c * Quantity + b

For instance, if the cost of making cars increases by $5 per vehicle, and the first vehicle costs $5,005 to make, the equation would be:

P = 5Q + 5,000

Demand curves represent the amount that would be sold at every price. Since the law of demand says that sales increase as prices fall, there's an inverse correlation between price and quantity. That means that demand curves take the form of:

Price = -w * Quantity + z

For instance, if car sales would increase by one for every $10 price reduction, and the most that anyone would pay for a car is $35,000, the demand equation would be:

P = -10Q + 35,000

Since there are two equations with two unknowns, you can solve for the price and quantity. First, solve for the equilibrium quantity by substituting the P in one equation for what it equals, then solve for Q.

5Q + 5000 = -10Q + 35,000

15Q = 30,000

Q = 2,000

Now, plug in the answer for Q into either equation to calculate the equilibrium price.

P = 5 * 2,000 + 5,000

P = 15,000

In this example, the equilibrium price — which is the theoretical market price — is $15,000. At that price, the math suggests that the company will sell 2,000 cars (Q = 2,000 from above).

A market-based pricing strategy is one that tries to set prices based on what customers are willing to pay. It starts by looking at what competitors charge for a similar product. Then, the company tries to adjust its price for how customers view their products compared to others. Market-based pricing contrasts with cost-based pricing, in which the company sets its price based on what it costs to make it, plus a mark-up.

With cost-based pricing, the price is built from the bottom up. For example, if the costs of goods sold (COGS) for a product is $5, the business executives would divide that value by the target gross profit margin. If the target profit margin were 50%, the cost-plus price would be $10 ($5 / .5 = $10). Cost-based pricing doesn’t consider what consumers are willing to pay or what competitors charge for their products.

Conversely, market-based pricing is built from the top down. The price decision doesn’t consider the cost of production. It first looks at how much the customers value the product, what competitors charge, and how different the company’s product is from the competition.

After determining the price, the management compares that value to the cost of production. If the resulting profit margins are good enough, they may move forward. Market-based pricing might result in higher or lower prices than cost-based pricing. While cost-based pricing is easier to determine, market-based pricing should produce higher total profits.