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.

Key Takeaways

  • The optimal market price, or equilibrium, is the point at which the number of items available, the supply, can be reasonably consumed by potential customers.
  • As market conditions change, the optimal price will change.
  • At any time, there is only a certain supply of goods available. Supply may be affected by the availability of raw materials, for example.
  • Demand may fluctuate depending on competitor products, an item's perceived value, or its affordability to the consumer market.

The Theory of Price Deconstructed

The theory of price, or 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 the equilibrium where the quantity of the goods or services provided match the demand of the corresponding market and its 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 a widget costs $5. A widget buyer is, therefore, willing to forgo the utility in $5 to possess the widget, and the widget seller perceives that $5 is a fair price for the widget. This simple theory of determining prices is one of the core principles underlying economic theory.

Supply and Demand and Their Relation to Price Theory

Supply denotes the number of products or services the market can provide including 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.

Equilibrium occurs when the price points are such that the number of items available, the supply, is consumed 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.

Real-World Example

Firms often differentiate their product lines vertically versus horizontally considering consumers' differential willingness to pay for quality. According to an article published in Marketing Science research by Michaela Draganska of Drexel University and Dipak C. Jain of INSEAD, many firms offer products that do not vary in quality but with characteristics such as color or flavor. Apple, for example, offers different iPhone models with varying prices and capabilities but each model comes in a variety of colors that are the same price. The study found that using uniform prices for all products in a product line is the best pricing policy. If Apple, for example, charged a higher price for a silver iPhone X versus a space gray iPhone X, demand for the silver model might fall, the supply of the silver model would increase, and Apple might be forced to reduce the price of that model.