What Is Price Determination?
The price of a product is the exchange value of the item under consideration, that is, the measure of how much you give to get the item. Prices do not always reflect the actual value of the product, that is, the value required to manufacture it. The price of a commodity covers not only the capital, labour, and land costs but also includes some profit for the sellers. Therefore, the prices of goods need regulation and a fair system of determination. In this article, we will go through several topics such as the importance of price determination that determines the level of prices in a market, and how to determine the price of a product.
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Introduction of Price Determination
Determination of prices in an ideal or free market is an outcome of the competition. In a free market, the cost of commodities and the services provided are a result of the balance between demand and supply. In such a scenario, no third-party needs to intervene in the determination of prices. However, no real-world market is ideal, and there is always some degree of monopoly, and here, the Government has to step in. The Government provides the upper and lower limits for the price of a commodity in most cases.
Now that we have a fair idea of what is price determination and the importance of price determination, we will move onto topics like what determines the level of prices in a market, and how to determine the price of a product.
Factors Determining the Price of a Product
What determines the level of prices in the market? To answer this question, we will look at the external factors that influence the Maximum Retail Price (MRP) of goods in the market. These factors are as follows.
Total Product Cost: The total cost of a product incorporates all the charges required for the product to complete its journey from manufacturing, through distribution, and up to selling and marketing. These include fixed, variable, and semi-variable costs.
Utility/Demand: The demand for a commodity can depend on the utility of the product or in many cases, on its price as well. Here comes the concept of elastic and inelastic demand. If the demand for a product is inelastic, that is, unchanging with time, the price of the commodity does not affect the demand significantly. On the other hand, for elastic commodities, a slight change in price causes a huge shift in the demand curve. People tend to lean towards cheaper substitutes.
Market Competition: If the level of competition for a certain product is high in the market, the manufacturers have to be careful while price setting. However, in a monopolistic market, the manufacturer can set any price for their product.
Government Regulations: In a monopolistic market, the company often misuses its advantage and sets a very high price for their products. To protect the interests of the customer, the Government intervenes and introduces price regulations. For example, a government can set a price ceiling for certain products or can declare a product as indispensable.
Enterprising Objectives: Often, companies have certain objectives that they want to achieve, for example, becoming a leader in quality control, obtaining share market supremacy, maximizing profits, or surviving in an overly competitive market. The company sets its product prices, keeping its objectives in mind.
Marketing Costs: Storage, Packaging, Distribution, and Marketing all together amount to a total of marketing costs which depends on the quality of these individual services. For example, the increasing sturdiness of the packaging will lead to heightened costs.
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Now that we know the factors that affect the market price of a commodity, we can try to answer the question: how to determine the price of a product?
How to Determine The Price of a Product?
"How to determine the sale price of a product" - understanding this is the main focus of this lesson. Let us start with the concept of the equilibrium price. The equilibrium price of a product is the cost at which demand and supply become equal. Statistically speaking, if we plot the demand and supply curve on a graph, the point at which they intersect is the equilibrium price.
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When we achieve the equilibrium price and quantity, we create a stable equilibrium. At this stage, there are no disturbances in the demand and supply rates. When the price reduces below equilibrium, the demand shoots up, and stocks fall, which results in the price increasing to the equilibrium point again. Similarly, when the prices rise above equilibrium, demand decreases, and to clear the stocks, price is reduced. Therefore, the forces of demand and supply primarily control the price of goods.
Solved Example
Q1. How to determine the price of a product in a real-world market?
Ans: In a real-world market with monopolistic trading, and other problems, a lot of factors determine the price of commodities, such as demand/supply, government regulations, company objectives, etc.
Did You Know?
Fixed prices of goods include the rent, salary of workers, etc. The variable prices cover the charges which change with demand and supply levels. The semi-variable prices change with time but are unaffected by demand levels.
The equilibrium price is such an ideological quantity that, at this level, all the demands of the customers are met completely, and at the same time, no stock is left unsold in the market. The equilibrium price is, therefore, also known as the market-clearing price.
FAQs on Introduction to Price Determination
1. What is meant by price determination in economics?
Price determination is the process through which the market forces of demand and supply interact to establish an equilibrium price for a good or service. In a free market, this is the price point where the quantity of a product consumers are willing to buy is exactly equal to the quantity producers are willing to sell.
2. What are the key factors that influence the price of a product?
Several factors determine the final price of a product. The most significant ones include:
- Cost of Production: This covers all fixed, variable, and semi-variable costs incurred during manufacturing and distribution.
- Utility and Demand: The perceived usefulness of the product and the overall consumer demand for it. The price sensitivity of demand (elasticity) is a crucial element.
- Market Competition: The number of competing firms in the market. In a highly competitive market, prices are often lower, whereas, in a monopoly, the seller has more pricing power.
- Government Regulations: Government-imposed controls like a price ceiling (maximum price) or a price floor (minimum price) can directly affect the price.
- Business Objectives: A company's goals, such as profit maximisation, gaining market share, or surviving intense competition, also guide its pricing strategies.
3. What is equilibrium price, and why is it also known as the 'market-clearing price'?
The equilibrium price is the specific price at which the quantity demanded by consumers equals the quantity supplied by producers. It is called the 'market-clearing price' because at this exact point, the market is perfectly balanced. Every unit produced is sold, and every consumer willing to buy at that price can do so, leaving no excess supply (surplus) or excess demand (shortage).
4. How is price determined under perfect competition?
In a perfectly competitive market, no single buyer or seller can influence the price. Instead, the price is determined by the collective actions of all buyers and sellers, often referred to as the 'invisible hand' of the market. If the current price is below equilibrium, it creates a shortage, causing buyers to bid the price up. If the price is above equilibrium, it results in a surplus, forcing sellers to lower their prices to clear inventory. This continuous adjustment pushes the price towards the equilibrium level where it stabilises.
5. What is the main difference between a price ceiling and a price floor?
A price ceiling is a maximum price set by the government, typically below the equilibrium price, to make essential goods more affordable. This often leads to a shortage. In contrast, a price floor is a minimum price set by the government, usually above the equilibrium price, to protect producers' incomes (e.g., Minimum Support Price for crops). This commonly leads to a surplus.
6. Why isn't setting the highest possible price always the most profitable strategy for a firm?
Setting the highest possible price is often counterproductive due to the Law of Demand, which states that as price increases, quantity demanded decreases. A very high price might lead to extremely low sales, resulting in lower total revenue and profit than a more moderate price. Firms must also consider factors like price elasticity of demand, the availability of substitute products, and long-term goals like building customer loyalty and market share.
7. What are the common real-world consequences of the government imposing a price ceiling?
When a government imposes an effective price ceiling (below equilibrium), it can lead to several unintended negative consequences. The most significant is a persistent shortage, as the quantity demanded exceeds the quantity supplied. This can also lead to non-price rationing mechanisms like long queues, seller bias, and the emergence of a black market where the good is sold illegally at a price higher than both the ceiling and the original equilibrium price.
8. How does a change in technology used for production affect the equilibrium price?
An improvement in technology typically lowers the cost of production. This encourages producers to supply more goods at every price level, causing the supply curve to shift to the right. As a result, the market will move to a new equilibrium with a lower equilibrium price and a higher equilibrium quantity, assuming demand remains constant.
9. What happens to the market surplus when the government sets a price floor?
When a government sets a price floor above the equilibrium price, it creates a market surplus. At this mandated higher price, producers are incentivised to supply more, but consumers are willing to buy less. This gap between the quantity supplied and the quantity demanded represents the surplus. To maintain the price floor, the government often needs to intervene by purchasing this excess stock.
