The concept of price theory came into being as a concept of valuation, i.e. the medium through which values are attached to goods and services. The concept of price theory arises as a result of the introduction of money into the economy.
Supply and Demand
The theory of price involves the process by which the monetary value of a commodity, service or factors of production is determined by the interplay of the forces of demand and supply. The emphasis is on how to allocate the scarce resources among alternative uses. This is generally referred to as price-mechanism. It involves the analysis of the consumer behavior (demand) and the producer behavior (supply).
Demand
Demand is defined as the number of goods and services that individuals are willing and able to buy at each and every price in some specified period of time.
The major factors that will affect the demand for a commodity include: (i) its (commodity’s) price; (ii) prices of related commodities; (iii) consumer’s income, (iv) consumer‟s taste or preference and (v) consumer‟s expectations about future prices of the commodity.
QX = f (PX, PY, I, T, E)
QX = Quantity demanded of Commodity X
PX = Price of Commodity X
PY = Price of Commodity Y
I = Consumer‟s Income
T = Consumer‟s Taste
E = Consumer‟s Expectation
Most often it is not easy or necessary to examine the influences of these five variables on the demand at the same time. This calls for a separate analysis of the individual factors on the demand. Of more importance is the relationship between the commodity and its price. This type of analysis is carried out by holding other factors constant and then examining the effect of the commodity‟s price on its demand.
QX = f (PX) ceteris paribus
The Law of Demand
This law deals with the relationship between demand and the price of the commodity. It states that the lower the price, the greater will be the quantity demanded, given that all other factors that influence demand remain unchanged.
From the above law relating solely to a particular commodity and its price, we can derive the demand schedule for a particular commodity given various prices. A demand schedule is a table listing the exact quantity of goods that will be bought at each of the specified prices, other factors remaining constant.
Supply
Supply is the quantity of a good or service that firms are willing and able to provide at each and every price in some specified period of time. The supply for a commodity is postulated simply as dependent on five major factors:
- Price of the commodity; (PX)
- Price of other commodities (PY)
iii. The technology of production (Tec)
- The goal of the firm and (G)
- Prices or rates of factor input/services (C)
Qx = f (PX, PY, Tec, G, C)
Change in the Quantity supplied Vis-à-vis the factor.
Changes in the factors affecting the quantity supplied of a commodity will result in the following relationships.
- Between QX and Px is a direct relationship
- Between QX and Py is an inverse relationship
iii. Between QX and Tec is a direct relationship
- Between QX and C is an inverse relationship
- Between QX and G is a direct relationship
As in the case of the demand, if we single out for analysis the effect of Px on Qx while keeping other factors constant we have the quantity supplied being determined by the price of the commodity alone.
QX = f(PX) ceteris paribus
From this analysis, we can construct the supply schedule and the supply curve. This analysis will also lead to the law of supply.
A supply schedule shows the number of goods or services firms are able and willing to sell at various prices per unit. On the other hand, a supply curve is a graph of the supply schedule. These two (schedule and curve) are derived under the assumption that other factors affecting supply except the price of the commodity itself are constant. Given the law of supply which states that there is a direct relationship between price and quantity supplied i.e as price increases, a larger quantity will be supplied.
In Summary,
Demand is defined as the number of goods and services a consumer is willing and able to buy at a given price over a period of time. Demand drives production through its impact on the commodity’s price, while the additional factors affecting demand include prices of related commodities, consumer income, and taste.
Supply is defined as the number of goods and services a producer is willing and able to offer for sale at a given price over a period of time. Its determinants include the commodity’s price, prices of other commodities, costs of factor inputs, the goal of the firm, government policy, and market structure environment.
The point at which quantity demanded equals quantity supplied is where the commodity’s price is determined and remains stable, referred to as the equilibrium price. The demand and supply curve is subject to change. The change can either be an outward shift or an inward shift for a demand curve or an upward or downward shift in the supply curve.
An outward shift of the demand curve, holding supply curve constant will lead to an increase in both the equilibrium price and quantity, while an inward shift of demand curve will lead to a decrease in both the equilibrium price and quantity.
A downward shift in the supply curve, holding the demand curve constant will lead to a decrease in the equilibrium price and an increase in the quantity, while an upward shift of supply curve will lead to an increase in the equilibrium price and a decrease in the quantity.
Simultaneous changes in both supply and demand lead to a combination of the basic effects of the specific shifts in the supply and demand curves.