Theory Of Price

What is the 'Theory Of Price'?

The theory of price is an economic theory whereby the price for any specific good or service is based on the relationship between supply and demand. The theory of price posits that the point at which the benefit gained from those who demand the entity meets the seller's marginal costs is the most optimal market price for the good or service.

BREAKING DOWN 'Theory Of Price'

The theory of price, also known as price theory, is a microeconomic principle that uses the concept of supply and demand to determine the appropriate price point for a good or service. The goal is to achieve equilibrium in which the quantities of goods or services provided match the corresponding market's desire and ability to acquire the good or service. The concept allows for price adjustments as market conditions change.

For example, suppose that market forces determine that it costs $5 for a widget. This suggests that widget buyers are willing to forgo the utility in $5 to possess the widget and that the widget seller perceives that $5 is a fair price in exchange for giving up the widget. This simple theory of determining prices is one of the core principles underlying economic theory.

Understanding Supply and Demand and the Relation to Price Theory

Supply denotes the amount of products or services the market can provide. This includes tangible goods, such as automobiles, or intangible goods, 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.

Demand applies to the market’s desire for the item, be it tangible or intangible. 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 impacted by an item's perceived value, or affordability, by the consumer market.

To achieve equilibrium, the goal is to locate a price point that allows the number of items available, referred to as the supply, to be reasonably covered by potential customers. If the price is too high, customers may avoid the good or service, resulting in excess supply. In contrast, if a price is too low, demand may significantly outweigh the available supply. Economists use price theory to find the selling price that brings supply and demand as close to the equilibrium as possible.