When you go into a store to buy something, do you ever consider why something has the price tag it does? Why do these apples cost $3.49 per pound, or why did a gallon of gas go from $5.85 to $6.15 in one week? Who made those decisions? Well, the short answer is price signals. For a better answer, keep on reading to learn about price signals, the strategy, and see some examples to make it make sense!
Price Signal Definition
What is the definition of a price signal? Price signals tell consumers and producers about changes in the market. The price of an item is the monetary value it has been assigned by its supply and demand in the market. Prices are important because they can be valuable indicators of trends in the market and they help producers answer the three basic questions in economics:
- What to produce?
- How to produce?
- For whom to produce?
Sending out a signal, pixabay
Answering these questions helps the economy run more smoothly and decide how to allocate resources efficiently. This is where price comes in as a signal to indicate what, how, and for whom to produce to ensure market efficiency. Price is a signal because it gives information to consumers and producers on which resources are scarce, where, and how best to produce them. The price of a good or service signals to producers whether to increase or decrease production. It signals consumers to increase or decrease consumption.
A price signal is an indicator that the supply and demand for a good or service in an industry need to change because of an increase or decrease in the price of the good or service.
The price of a good or service is also a signal of the quality of a product. Higher prices are typically associated with better quality, whereas lower prices signal lesser quality, although it doesn't always hold.
Price signaling is also a strategy used by businesses in the same industry, where they discuss the pricing of their goods and services amongst each other. Competing firms do this so that they could all price their products within the same price range to remain competitive with each other. The debate is ongoing on whether or not signaling should be illegal under United States antitrust laws.1
Antitrust Laws
Several antitrust laws in the United States that are meant to protect consumers from predatory business practices by large companies that would control prices and prevent fair competition in the market. Antitrust laws forbid monopolies and dismantle trusts that are collections of companies that are set up to restrict competition in a particular industry. This helps ensure that consumers have choices in the market and they help prevent market failures from lack of competition.
Price Signal Theory
The price signal theory is where prices are signals to consumers and producers in the economy. Prices signal changes in demand, supply, and changes in production, and they indicate the quality of the good or service to the consumer. These are all factors that affect the price of a good or service. Prices are also considered to be neutral, meaning that they should not benefit either the consumer or the producer. They should represent a compromise between the buyer and the seller since the price is the result of bargaining between the two parties.
Increased prices signal to consumers that they must decrease their demand for a good and consume less of it. This may be due to changes in the price of input materials, transport costs, or that demand has become too much for producers to keep up with. A lower price signals that consumers should be buying more of a good because there is an excess in the market that is driving down prices.
Figure 1. An increase in price signals a decrease in demand, StudySmarter Originals
Figure 1 shows the effect of an increase in price (P) on demand (D). As the price increased from P1 to P2, the quantity demanded decreased from D1 to D2. Initially, consumers were at point A, when prices were low and the quantity demanded was high, but as the price increased, it signaled consumers to move from point A to point B along the demand curve. If there is a decrease in price from P2 to P1, then consumers would increase the quantity demanded.
Price signals in production tell the producer to increase or cut back on production meaning that there will be a change in supply. High prices signal the producer to increase their production to keep up with the demand and close any shortage gaps. Low prices signal the opposite reaction is necessary. Producers should cut back on production to reduce any surplus in the market.
Figure 2. An increase in price signals an increase in quantity supplied, StudySmarter Originals
Figure 2 shows how a price (P) increase signals producers to increase the quantity (Q) supplied of a good. As price increases from P1 to P2, we move from point A on the supply curve to point B. This means that the quantity supplied of a good increases from Q1 to Q2. If prices were to decrease from P2 to P1, then this would signal producers to supply less of the good. We would move from point B to point A, and from Q2 back to Q1.
The price of a good is often taken as a signal of the good's quality. If a good is expensive relative to another good with comparable functions, then the buyer tends to assume that the more expensive product is of higher quality. Either the function is superior or the materials used in production are better than that of the competition. This is not always the truth of the matter, but price influences our perception of material things. The price signal theory here relies on the consumer having imperfect or partial information on the quality of the good.
Price Signaling Strategy
The price signaling strategy is used by producers to signal the quality of their product through its price. Price signaling helps a firm's product be more competitive in the market because it acts as a measure with which buyers can compare products. Since buyers tend to assume that more expensive products are of higher quality, they will want to purchase the more expensive product.
Sometimes, it is not necessarily true that the more expensive product is better. This is where firms rely on the consumer not having all the information necessary to accurately judge the quality of the product they are buying. In some cases, firms make this information difficult for consumers to access as well as making it generally hard to find.
Oftentimes, these steps are not even necessary because a lot of the times the buyer relies on the company to provide them with true and accurate information regarding the quality, since the consumer is most likely not an expert on the product.
Price Signal Examples
Examples of price signals can be found across most industries. Buyers and producers use prices as signals to help make economic decisions. To sellers or producers, prices can signal if they need to increase production to meet consumer demand or if production needs to be decreased to reduce surplus units on the market. To buyers or consumers, prices can signal to purchase more of a product if the price is low or that they need to purchase less if the price is high.
Examples of how price signals influence demand can be found in most markets since the price is often a determining factor of how much of a product we demand. Let's take a look at some examples to help us understand.
When consumers go into the grocery store they might see that apples have decreased in price from $2.85 per pound to $2.00 per pound. This price decrease is the result of a larger annual apple harvest. A new pesticide came onto the market and farmers were able to reduce losses due to pests by 75%.
Since the price of apples decreased, consumers should buy more apples since they are cheaper and reduce the surplus or excess of apples on the market.
On the other hand, bananas have increased in price from $1.99 per bundle to $3.25 per bundle because damage from a disease caused a large portion of the crop to fail, causing a shortage in the supply of bananas. In this case, the price signals to buyers that they should reduce their consumption of bananas to cope with the increased price.
An example of how prices signal to producers to increase production could be a change in the price of a good such as hemp fibers.
If fashion trends shift away from materials like cotton and polyester and towards using hemp fibers to make clothing, then the price of hemp will increase. This means that producers of hemp will want to increase their production and producers of cotton may want to shift to producing hemp instead.
Now, if the increasing popularity of hemp fibers causes the price of cotton to fall then, those farmers producing cotton will want to reduce production and consider switching over to a more profitable crop.
Next, let's take a look at an example of how price can signal the quality of a good to the consumer.
Imagine you are making the choice when buying a winter jacket. One coat is from a brand that produces alpine sports and hiking gear. This jacket boasts the best function for water and wind resistance. The price tag reads $149.99.
Another jacket from a similar brand claims the same properties as the more expensive one but its price is only $74.49. Maybe this jacket has fewer pockets and the zippers are not as smooth, but these things have no impact on the jacket's effectiveness in protecting you from the winter.
You decide to go with the more expensive jacket because you feel that if the jacket has a higher price than the other one, it indicates superior materials and function.
Price Signaling Competition Law
What role does price signaling play in competition law? Price signaling can also occur when companies indirectly, through revealing their prices, communicate their intentions to raise or lower their prices to each other. The problem with companies communicating with each other about price is that it compromises the neutrality of price. Price is supposed to be neutral and not benefit the buyers or sellers. When prices are flexible as they are in a free market economy, they can rise and fall to best suit the market and competition. When firms interfere with prices, they are preventing fair competition between buyers and sellers.
What exactly is a free market economy? Read our explanation - Market Economies to find out!
Manipulating prices by signaling to other firms in the industry intentions for pricing is a gray area of the law. Signaling is not explicitly mentioned in antitrust laws but it bears a resemblance to price-fixing, which is when firms explicitly agree to charge the same price for a product. Price-fixing is illegal. Price signaling is similar because it informs firms of another's intentions to change prices and allows them to respond accordingly. This compromises fair competition between buyers and sellers.1
Price Signals - Key takeaways
- Price signals tell consumers and producers about changes in the market. Prices are important because they can be valuable indicators of trends in the market.
- Prices signal changes in demand, supply, and changes in production, and they indicate the quality of the good or service to the consumer.
- Increased prices signal to consumers that they must decrease their demand for a good and consume less of it. Price signals in production tell the producer to increase or cut back on production meaning that there will be a change in supply.
- The price signaling strategy is used by producers to signal the quality of their product through its price. Price signaling helps a firm's product be more competitive in the market because it acts as a measure with which buyers can compare products.
- Price signaling can also occur when companies indirectly, through revealing their prices, communicate their intentions to raise or lower their prices to each other. This compromises the neutrality of the price.
References
- Paula W. Render, J. Bruce McDonald, and Thomas York, Sending the Wrong Message? Antitrust Liability for Signaling, 2016, file:///C:/Users/Aisch/Downloads/Fall16RenderC.pdf
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