What Is Theory of Price? Definition In Economics and Example

What Is the Theory of Price?

The theory of price is an economic theory that states that the price for a specific good or service is determined by the relationship between its supply and demand at any given point. Prices should rise if demand exceeds supply and fall if supply exceeds demand.

Understanding the Theory of Price

The theory of price—also referred to as "price theory"—is a microeconomic principle that says the market forces of supply and demand will determine the logical price point for a particular good or service at any given time.

In a free market economy, producers typically want to charge as much as they reasonably can for their goods and services, while consumers want to pay as little as they can to obtain them. Market forces will cause the two sides to meet somewhere in the middle, at a price consumers are willing to pay and that producers are willing to accept.

When the quantity of a good or service that's available matches the demand of potential consumers for it, the market is said to achieve equilibrium. The concept of price theory allows for price adjustments as market conditions change.

Relationship of Supply and Demand to Price Theory

Supply denotes the number of products or services that the market can provide. This includes both tangible goods, such as automobiles, and intangible ones, such as the ability to make an appointment with a skilled service provider. In each instance, the available supply is finite in nature. There are only a certain number of automobiles available and only a certain number of appointments available at any given time.

Supply may be affected by forces that are beyond a producer's control, such as the availability of raw materials.

Demand applies to the market's desire for tangible or intangible goods. At any time, there is also only a finite number of potential consumers available. Demand may fluctuate depending on a variety of factors, such as whether an improved version of a product is available or if a service is no longer needed. Demand can also be affected by an item's perceived value by the consumer market.

As mentioned earlier, equilibrium occurs when the total number of items available—the supply—can be consumed by potential customers. If a price is too high, customers may avoid the goods or services or find other alternatives. This would result in excess supply and possibly cause producers to lower prices.

In contrast, if a price is too low, demand may significantly outpace the available supply, causing prices to rise again.

The optimal price, taking into account both supply and demand, is also referred to as the clearing price.

Example of the Theory of Price

Companies often differentiate their product lines vertically, rather than horizontally, considering consumers' differential willingness to pay for quality. As noted by Michaela Draganska of Drexel University and Dipak C. Jain of INSEAD in the journal Marketing Science, many firms offer products that vary in characteristics like color or flavor, but that do not vary in quality.

Their study found that using uniform prices for all products in a particular product line tends to be the best pricing policy for producers.

For example, Apple Inc. offers several different MacBook Pro laptop computer models, with varying screen sizes, capabilities, and prices. The customer has a choice of two colors: silver and space gray. If Apple charged a higher price for a 13-inch silver MacBook Pro versus an otherwise identical space gray one, demand for the silver model might fall, and the available supply of the silver model would increase. At that point, Apple might be forced to reduce the price of that model.

The Bottom Line

The theory of price in microeconomics states that the price of a particular good or service is determined by the relationship between producer supply and consumer demand at any given point. Prices should rise if demand exceeds supply and fall if supply exceeds demand. When supply and demand are equal, the market is said to have achieved equilibrium.