Clearing price is the equilibrium monetary value of a traded security, asset, or good. This price is determined by the bid-ask process of buyers and sellers, or more broadly, by the interaction of supply and demand forces. Clearing prices are most stable in a liquid market. In illiquid markets, with few buyers and sellers, it may take longer for prices to reach equilibrium.
- In microeconomics, the clearing price refers to the price point where supply and demand are in equilibrium. It is also known as the equilibrium price.
- In a free market, the clearing price is reached through price discovery as buyers and sellers attempt to find the most beneficial price.
- In securities markets, the clearing price is reached through the bid-ask process on the market order books.
- While liquid markets are likely to reach equilibrium quickly, markets that are illiquid or thinly traded are more likely to face volatility or slippage.
- For some goods, prices respond slowly to changing market dynamics. These are referred to as sticky prices.
How a Clearing Price Works
In any exchange, sellers want the highest price possible for a security or asset, while investors interested in buying it desire the lowest purchase price possible. At some point, a mutually agreeable price is reached between buyers and sellers. It is at this point that economists say the market has "cleared" and a transaction has taken place.
Supply and demand are key elements of the bid-ask process in a securities market. The clearing price of a security or asset will be the price at which it was most recently traded. In an actively traded market with many participants on both sides, price discovery can be quick, particularly when bid-ask quotes are updated continuously in real-time on an electronic exchange. For illiquid or thinly traded securities, such as distressed debt, it will take longer to find a stable clearing price because there are fewer buyers and sellers.
For products or services, the market-clearing price is also determined primarily by the interplay of supply and demand. The intersection of the downward-sloping demand curve and upward-sloping supply curve represents the equilibrium price, or clearing price, for the product or service.
Take a high-end smartphone, for example. If the manufacturer sets the price too high, then a surplus of its smartphones will develop; if it sets the price too low, then demand may leave the manufacturer short of inventory. In either case, assuming no friction in the market, an adjustment process between supply and demand will take place to find the clearing price for the smartphone.
However, clearing prices may not respond immediately to changing market conditions. Price stickiness refers the tendency of some goods to adjust more slowly than the market changes, even when new dynamics suggest a different optimal price. A classic example of this is wage stickiness: employers are usually unlikely to cut the salaries of their employees, except in cases of severe downturns.
Stickiness refers to the tendency of certain prices to resist movement, even in changing market conditions. Wages are a well-known example of a sticky good.
Example of a Market Clearing Price
For a simple example of how clearing prices are set, imagine a stock called XYZ, that is trading on a certain stock market. On a typical day, the order book reports a daily transaction volume of $1 million, with share prices trading in a narrow band between $95 and $100. In other words, about 10,000 shares change hands every day, and the market is in equilibrium between buyers and sellers.
However, these are not the only prospective trades. Some buyers might have open orders for lower prices, in anticipation of sharp price drops. Some sellers would likewise have open orders for extremely high prices, in anticipation of a price spike.
Next, suppose a wealthy investor enters the market and wishes to spend $1 million on XYZ stock in the open market. One might expect that this investor would be able to buy 10,000 shares, but this is unlikely, due to the limited supply. The investor would quickly buy up all the shares in the $95-$100 range, before moving on to buy offers priced at $110, $120, or even $200. By the end of the trading day, the clearing price for XYZ could be significantly higher than it was when the investor entered the market.
The Bottom Line
Market clearing prices form one of the key ideas in market economics. When buyers enter the market seeking the lowest possible price, and sellers seek the highest price, the market eventually reaches an equilibrium point where demand is exactly equal to supply. This idea is also key to securities markets, where prices are established through the bid-ask process on exchange order books.
What Is a Market Clearing Price?
The market clearing price is the price at which the demand for a good by consumers is equal to the number of goods that can be produced at that price. At this price, the supply and demand are exactly equal: there are no unused goods waiting to be sold, and no buyers who are unable to buy.
How Are the Equilibrium Price and the Market Clearing Price Related?
The phrase "equilibrium price" is often used interchangeably with "market clearing price." Both refer to the price at which the number of goods for sale is exactly equal to the quantity that buyers wish to purchase. In other words, it is the price at which the market is in equilibrium.
How Do You Find the Market Clearing Price?
The market clearing price is reached through price discovery. Both buyers and sellers will attempt to find the most advantageous prices for their interests. Eventually, the market will reach equilibrium at the price point where the number of willing buyers is equal to the number of willing sellers.
What Happens If the Price Falls Below the Market Clearing Price?
If price falls below the market clearing price, buyers will buy up all of the available goods, causing a shortage in the market. This shortage causes prices to rise, until they reach the equilibrium price. Likewise, if prices rise above the market clearing price, suppliers will have a surplus of unsold goods, that can only be reduced by lowering prices.