How Markets Set a Price

Part 3 worked out what things are worth: list the money something will bring in the future, discount each amount back to today, and add them up. But what something is worth and what it sells for aren’t the same. This part is about the second one: how buyers and sellers actually arrive at a price.

I expected markets to be the complicated part. The basic mechanism turned out to be simple, and the same mechanism runs tutoring, stocks, oil and currencies. What’s hard is how the markets push on each other, which is where this part ends.

As before, I’ve kept the questions I had along the way and what cleared them up.

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How a Price Gets Set

• Market: anywhere buyers and sellers of the same thing meet and trade. It can be a building, a website, or just a town where everyone knows the going rate.
• Demand: how much buyers want to buy at each possible price.
• Supply: how much sellers are willing to sell at each possible price.
• Equilibrium price: the price where the amount buyers want equals the amount sellers offer.

Take the market for tutoring in Sam’s town. Families are the buyers. Sam’s center and the other tutors in town are the sellers.

Demand: how many students want tutoring at each monthly price

As the price goes up, fewer families want it. Every family values tutoring differently: the most each one would pay, its willingness to pay, is different. At $50, almost any family that cares about grades signs up. At $150, only the ones who value it a lot still do.

Supply: how many tutoring spots get offered at each price

As the price goes up, more spots appear. That’s opportunity cost, the value of the best thing you give up. At $50, teaching barely beats Leo’s other options, so few tutors bother. At $150, teaching beats a lot of other work, so tutors take on more students and new centers open.

Putting them together

Above $100, prices drift down. Below $100, they drift up. The only price that stays put is $100, the equilibrium. That’s why Sam charges $100. She didn’t pick it freely; it’s where the market settles. At $125, families would go to cheaper tutors. At $75, she’d have a waitlist and be leaving money on the table.

Nobody set $100. No one in town calculated it. It came out of thousands of separate decisions by families and tutors, each doing what made sense for them. That’s what people mean when they say a market “discovers” a price.

It also ties the price back to value. Every family paying $100 values tutoring at $100 or more. The gap between what a family would have paid and the $100 it actually pays is its consumer surplus, the value it gets for free.

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What Makes Prices Move

• Shift in demand: buyers want more, or less, at every price, because something other than the price changed: more reasons to want tutoring, more families in town, or a cheaper substitute appearing.
• Shift in supply: sellers offer more, or less, at every price, because their costs or options changed: rent goes up, more tutors move to town, or better tools let each tutor teach more.
• Shortage: buyers want more than sellers offer at the current price. Waitlists form and prices rise.
• Surplus: sellers offer more than buyers want at the current price. Spots sit empty and prices fall.

A change in price doesn’t shift demand. If tutoring gets pricier, fewer families buy, but that’s moving along the same demand table. A shift means the whole table changes.

Each example starts from the equilibrium above: $100 a month, 120 students.

Demand rises. College admissions get more competitive, and every family wants more help. At every price, 40 more students want tutoring:

At $100, 160 students now want spots but only 120 exist: a shortage. Centers raise prices. At $125 there are empty spots, so prices don’t go that high. They settle where the two meet, about $112.50, with 140 students.

The higher price does two jobs at once. It hands the scarce spots to the families who value them most, and it pulls in more supply, as tutors take on more students and new centers open. Nobody coordinates any of that. The price does it.

Supply falls. Rents in town double, so some centers close. At every price, 40 fewer spots are offered:

At $100 there’s now a shortage of 40 spots. Prices rise until the two meet, at about $112.50, with 100 students. It’s the same price rise as before, for the opposite reason, and this time fewer students get tutored.

An AI tutor arrives. A cheap AI tutoring app launches. For some families it’s good enough, so they stop paying for a human. At every price, 60 fewer students want human tutoring:

At $100, 60 spots now sit empty: a surplus. Centers cut prices to fill them, and they settle around $81, with 90 students.

Families who switched to the app pay less. Families who stuck with human tutors pay less too. But Sam earns less per student and has fewer of them, and Leo’s teaching skill is worth less. As prices fall, some tutors leave for other work, which is the market shrinking supply on its own.

The four directions

So when a price moves, the first question is whether buyers wanted more or sellers offered less. Both raise the price, but they mean very different things. A rising price with rising sales is a booming market. A rising price with falling sales is a squeeze.

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How Financial Markets Trade Minute by Minute

The tutoring market settles slowly, over months. Financial markets do the same thing in fractions of a second.

• Exchange: the marketplace where shares are traded, like the New York Stock Exchange or Nasdaq. Today it’s computers matching orders.
• Limit order: an instruction like “buy 500 shares, but only at $99.90 or less.”
• Market order: an instruction like “buy 500 shares now, at the best price available.”
• Order book: the list of all waiting limit orders, buyers on one side and sellers on the other.
• Bid and ask: the bid is the highest price any buyer is offering right now. The ask is the lowest price any seller will accept.
• Spread: the gap between the bid and the ask.
• Liquidity: how easily you can buy or sell without moving the price much.

Brightpath Learning is a made-up chain of tutoring centers, like hundreds of Sam’s, listed on the stock market. At 10:00 a.m., here’s what’s waiting in its order book:

The best bid is $99.90 and the best ask is $100.10, so the spread is 20 cents. Nobody trades yet, because no buyer will pay what any seller wants. When people say “the stock is at $100,” they mean the price of the most recent trade, which sits somewhere in this range.

A trade. Someone sends a market order to buy 600 shares. The exchange fills it from the cheapest sellers up:

1. 400 shares at $100.10, the best ask, all of it.
2. The remaining 200 shares at $100.20, the next ask.

The last trade happened at $100.20, so the stock now shows as $100.20. The price rose 10 cents because a buyer wanted more shares than were offered at the lowest price. That’s supply and demand, one order at a time. A large sell order does the reverse: it works down through the bids, and the price falls.

News. At 10:05, Brightpath announces new contracts that will lift its expected profit growth from 3% to 4% a year. Its profit next year is $50 million, and investors discount its future profits at 8% a year. For a stream of profits that grows at a steady rate forever, the value works out to next year’s profit divided by the gap between the rate and the growth, which is the growing perpetuity formula from Part 3:

$50 million ÷ (0.08 − 0.04) = $1.25 billion, or $125 a share across its 10 million shares, up from $100

Within seconds, sellers cancel their asks near $100 and repost them higher, since nobody wants to sell at $100 something now worth around $125. Buyers raise their bids. Trades happen at $105, $112, $118, and the price settles near where most traders’ new estimates land. Nobody announces a new price. It comes out of thousands of traders updating their orders. That’s how a market turns valuations into a price.

Liquidity and market makers. Brightpath’s order book is deep: lots of shares waiting close to the current price, so buying 600 shares moved the price only 10 cents. Selling Sam’s center, or a house, is the opposite. There might be one or two interested buyers, the gap between their offer and the asking price can be thousands of dollars, and it takes months. That’s low liquidity, and it’s one reason hard-to-sell things are discounted at higher rates: it’s harder to get out.

Much of the liquidity in big stocks comes from market makers, firms that constantly post both bids and asks. They buy at $99.90, sell at $100.10, and earn the spread many thousands of times a day. That keeps the spread narrow for everyone else.

The orders come from individuals trading through apps, index funds and pension funds investing retirement savings, hedge funds betting on mispriced stocks, and high-speed trading firms. They all have different forecasts and rates, which is exactly why they trade: one thinks $100 is cheap, another thinks it’s expensive.

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The Stock Market

• Primary market: a company selling new shares and getting the money. The first time it does this publicly is its IPO, initial public offering.
• Secondary market: investors trading shares with each other afterward. The company gets nothing from these trades.
• Index: a single number that tracks a group of stocks, so you can see how they’re doing together.
• Market-cap weighted: bigger companies count for more in the index, in proportion to their total market value, their market cap.
• Index fund: a fund that buys every stock in an index, in the same proportions.
• Bull market and bear market: prices up 20% or more from a low, or down 20% or more from a high. A drop of 10% is a correction.

When the news says “the market is up 1% today,” it almost always means the S&P 500 rose 1%.

A tiny index. Say the whole market were three companies:

One day, Brightpath jumps 10%, the tech company rises 2%, and the bank falls 1%:

Brightpath had by far the best day, but the tech company moved the index more, because it’s eight times bigger. In recent years a handful of the largest tech companies, many of them tied to AI, have made up a big share of the S&P 500. So “the market is up” can mostly mean “a few giant companies are up” while the typical company is flat.

Points versus percent. “The Dow rose 400 points” means nothing on its own. 400 points on an index at 40,000 is 1%. On an index at 4,000 it would be 10%. Always look at the percentage.

Why the whole market moves together. Every stock’s price comes from the same three dials: how much the company will pay its owners, how fast that grows, and the rate those future payments are discounted at. Some of those dials are shared by every company:

When the whole market moves, it’s usually one of those shared dials. When one stock moves on its own, it’s usually news about that company’s own forecast, like Brightpath’s new contracts.

Index funds. Most people’s retirement savings sit in index funds. Instead of guessing which companies will do best, they buy the whole index. It’s very hard to pick winners better than the market as a whole, consistently and after costs, so owning everything cheaply is a strong default. It also means that as money flows into index funds, the biggest companies get the biggest share of it, just because of weighting.

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The Bond Market

• Treasuries: bonds issued by the US government. Short ones, up to a year, are bills; 2 to 10 years are notes; 20 to 30 years are bonds. People often call them all bonds.
• Corporate bonds: bonds issued by companies.
• Credit rating: a grade from agencies like S&P or Moody’s for how likely a borrower is to repay. AAA is the safest. BBB and above is investment grade. Below that is high yield, also called junk.
• Credit spread: how much more a riskier borrower pays than the US government for the same length of time.
• Yield curve: the yields on Treasuries of different lengths, lined up from shortest to longest.
• Inverted yield curve: short-term yields higher than long-term ones.

The yield curve. A typical curve might look like this:

Each point answers the same question: what does it cost the US government to borrow for this long? The shape says two things.

Longer usually pays more. Lending for 30 years ties your money up for a long time, and long bonds lose much more value when rates rise. In Part 3, a rise in rates from 4% to 6% knocked a 30-year bond down to about $725 per $1,000, while a 3-year bond barely moved. Lenders want extra for that risk, the term premium, so the curve normally slopes upward.

The shape shows what people expect the Fed to do. A 2-year yield is roughly the average Fed rate people expect over the next two years. Here the 3-month yield is 3.9% and the 2-year is 3.7%, so traders expect the Fed to cut a little over the next couple of years.

When the curve inverts. Say the 3-month pays 5% and the 10-year pays 4%. Traders expect rates to fall, usually because they think the economy will weaken and the Fed will have to cut. An inverted curve has come before most US recessions, which is why it gets so much attention. It isn’t a perfect signal: the curve inverted in 2022 and stayed that way for a long time without a recession following right away.

Credit spreads. Say Brightpath borrows by selling 5-year bonds. Investors compare it with the government:

An interest rate is built from layers: what money can earn safely, plus extra for the chance of not being repaid. The spread is that extra for risk, with a market price on it.

Spreads move together, which makes them a good gauge of fear. When investors get nervous, they demand more from every risky borrower, spreads widen, and companies find borrowing harder right when they may need it most. When spreads are narrow, investors are calm, sometimes too calm.

The stock market gets the headlines, but the bond market sets the price of borrowing for everyone: the government, companies, and through mortgage rates, homeowners. The 10-year Treasury yield is the safe rate underneath almost every valuation. When people say “the bond market is telling us something,” they usually mean the curve’s shape or the spreads are hinting at where the economy is headed.

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Commodities and Futures

• Commodity: a raw good where one unit is as good as any other: oil, wheat, copper, gold, natural gas.
• Spot price: the price to buy it now, for immediate delivery.
• Futures contract: an agreement made today to buy or sell a fixed amount on a set future date, at a price agreed today.
• Hedging: using a contract like this to remove a risk you don’t want.
• Speculating: taking on that risk on purpose, hoping to profit from the price moving.

It’s spring. A farmer is planting wheat she’ll harvest in September. A bakery will need that wheat in September. Wheat’s spot price today is $6 a bushel. Both are nervous, in opposite directions: the farmer worries the price will fall by harvest, and the bakery worries it will rise.

So they sign a futures contract: the farmer delivers 10,000 bushels in September, and the bakery pays $6.20 a bushel, whatever the spot price is then.

Whichever way prices go, one side ends up wishing it hadn’t signed. That’s not the point. Both got certainty: the farmer knows her income and the bakery knows its costs, months ahead. They gave up the chance of a lucky price to get rid of the risk of an unlucky one.

The contract says $6.20 rather than $6 because buying wheat now and holding it until September costs money: storage, insurance, and the interest the money could have earned meanwhile. So the price for later delivery usually sits a bit above the spot price. In a shortage the reverse can happen, and wheat today costs more than wheat later.

Speculators. Most futures are traded by people who never want to touch a bushel. A speculator who thinks wheat will hit $8 buys September contracts at $6.20 and sells them before delivery. If wheat rises, the contracts are worth more and they profit. If it falls, they lose. They get a bad reputation, but they’re the ones taking the other side when a farmer wants to hedge and no bakery is around. They’re paid for carrying the risk nobody else wanted.

Why a commodity can’t be valued like a stock. Valuing a stock, a bond or land means forecasting the money it will pay you and discounting it to today. A barrel of oil in storage pays nothing: no profit, no interest, no rent. With no stream of money, there’s nothing to discount. Its price is whatever buyers will pay, set by supply and demand:

• Oil moves with how much the world is using and how much is being pumped. A war near oil fields or a production cut is a supply drop: price up, less sold.
• Copper goes into buildings, cars and power lines, so its price tends to rise when the world economy grows. Traders call it a gauge of economic health.
• Gold is mostly held, not used. People buy it when they’re worried about inflation or crises, so its price often rises when they’re scared.

An oil field is different, because it produces oil every year. Say it pumps 100,000 barrels a year for 10 years, sold at about $70 a barrel with $30 a barrel in costs. That’s $4 million of profit a year. Discounting each year’s $4 million at 10%, since oil prices swing a lot, and adding them up gives about $24.6 million. So the field can be valued, but its value still depends on the oil price, which is why oil companies’ stocks move when oil does.

Commodities are the inputs to almost everything. When oil rises, shipping, flying, farming and plastics all get more expensive, so prices across the economy rise. That’s one of the most common sources of inflation. And data centers need huge amounts of electricity, copper and chips, so AI demand is now one of the forces moving some of these markets.

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Currencies

• Exchange rate: the price of one currency in another. “£1 = $1.25” means one British pound costs $1.25.
• Foreign exchange (FX) market: where currencies are traded, mostly by banks, companies and investors. It trades trillions of dollars a day, more than any other market.
• Appreciate and depreciate: a currency appreciates when it buys more of other currencies and depreciates when it buys less.

Sam orders £1,000 worth of books from a British publisher. The publisher wants pounds, so Sam’s bank sells her dollars and buys pounds.

The books didn’t change. Only the price of the pound did.

What sets the rate. A currency is priced like anything else: by supply and demand. People need foreign money to buy foreign things. Imagine all the swapping between two currencies happens at one giant booth. In reality it’s banks trading with each other, but it works the same way. For dollars:

When demand for dollars rises faster than supply, the dollar strengthens. What tends to shift it:

1. Interest rates. If US rates rise, US bonds pay more than bonds elsewhere, so investors buy dollars to buy them. This is the biggest day-to-day force, and it’s why the dollar often jumps when the Fed raises rates.
2. Inflation. If prices rise faster in the US than abroad, each dollar buys less stuff, and over time less of other currencies too.
3. Growth. If US companies look like the best place to invest, as during an AI boom, foreigners buy US stocks, which means buying dollars first.
4. Fear. In a crisis, investors worldwide rush into what feels safest, usually US government bonds. So the dollar often strengthens when the world is scared, even when the trouble started in the US.
5. Trade. If foreigners buy more American goods, they need more dollars.

Who wins and who loses

That last row matters. Many countries and companies borrow in dollars. When the dollar strengthens, their debts grow in their own currency overnight, which is how a Fed decision in Washington can cause a crisis somewhere else.

Floating, pegged and managed. Most big currencies, like the dollar, euro, yen and pound, float: their price moves every day with supply and demand. Some countries instead peg their currency: the government promises to hold it at a fixed price against another currency, usually the dollar. Hong Kong has promised since 1983 that one US dollar will cost about 7.8 Hong Kong dollars.

To see how each works, take the rupee and round today’s rate to ₹100 per dollar. On a normal day, Indians want $10 billion and foreigners offer $10 billion, so the price holds. Then oil prices jump, and Indian importers need $12 billion while foreigners still offer $10 billion.

Under a float, the higher price fixes the gap by itself. At ₹105 a dollar, imports cost Indians more, so they buy a bit less from abroad, and Indian services cost foreigners less, so they buy more. Under a peg, the gap is there again tomorrow if oil stays high, and the reserves keep draining. Eventually the country has to let the price move, or make the shortage of dollars go away by raising interest rates to attract foreign money or squeezing imports.

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One Shock, Every Market

Each market so far was explained on its own. In reality they’re all linked, so one event ripples through every one of them. Here’s one: a war disrupts a major oil route, and 5% of the world’s oil supply is suddenly cut off.

Day 1: commodities. Oil demand barely responds to price in the short run, so a 5% supply drop pushes oil sharply higher, say from $70 to $110 a barrel. Price up, less sold.

Day 1: stocks. Investors rerun their forecasts company by company:

Day 1: currencies. Oil exporters like Canada and Norway earn more, so their currencies tend to strengthen. Countries that import most of their oil pay more, so theirs weaken. Scared investors move money into US government bonds, which pushes the dollar up.

Weeks later: inflation. Oil goes into almost everything. Gas, shipping, flights, plastics and food all get more expensive. Sam’s electricity and the shipping on her books go up.

Weeks later: bonds. Two forces pull in opposite directions. Inflation fear pushes yields up, as lenders demand more and expect the Fed to raise rates. Recession fear pushes long yields down, as people expect the Fed to cut eventually and buy safe long bonds. Often short yields rise while long yields fall, so the yield curve flattens or inverts. Credit spreads widen, so borrowing gets more expensive for weaker companies right when their costs are rising.

Months later: the Fed has to choose. Inflation is up, which says raise rates. The economy is weakening, which says don’t. Rising prices and slowing growth at once is called stagflation, and it’s the worst situation a central bank can face. If it raises rates, inflation cools but the economy slows further and every asset is repriced down. If it holds, the economy is spared for now, but inflation may become entrenched as people start expecting it.

Months later: back to Sam. Families are spending more on gas and groceries, so some cut tutoring. Demand falls while Sam’s costs rise. Her profit shrinks from both sides, and her center is worth less, both because its forecast fell and because rates may be rising.

The loop closes. If the economy slows enough, people drive less, factories make less, and oil demand falls. The oil price comes back down, partly undoing the shock that started it all.

This is roughly what happened in the 1970s, when oil embargoes helped cause years of high inflation and weak growth in the US.

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What’s Next

A market is where buyers and sellers meet, and the price settles where what buyers want matches what sellers offer. Prices move when demand or supply shifts, and whether the amount sold rises or falls tells you which one moved. Financial markets do this in fractions of a second through order books. Stock indexes measure many prices at once, weighted by size, and move together when shared forces shift: rates, growth and fear. Bond yields set the price of borrowing for everyone. Commodities are priced by pure supply and demand, and because some, like oil, are hard to do without, small shortages cause big swings. Currencies are priced the same way, mostly by interest rates, inflation and fear, and some governments choose to hold them fixed. And all of these are connected, so one event moves every market at once.

Part 5 is about inflation: how it’s measured, what causes it, who wins and loses, and how central banks fight it.