The price of a product is determined by the law of supply and demand. Consumers have a desire to acquire a product, and producers manufacture a supply to meet this demand. The equilibrium market price of a good is the price at which quantity supplied equals quantity demanded. Graphically, the supply and demand curves intersect at the equilibrium price.
Effect of Prices on Demand
Generally, consumers are willing to pay a particular price for a product depending on their income levels and intensity of desire to own the product. This relationship is expressed in economic terms by the demand curve. If the price of a good goes up, consumers will buy less of it. Conversely, consumers will purchase more of a product if the price goes down.
However, economic forces are not always that simple. Other factors come into play to influence the equilibrium price as determined by the supply-demand equations of economics.
Factors That Shift the Demand Curve
When a change increases the desire of consumers to purchase a good, the demand curve shifts to the right. If the change decreases consumers' willingness to acquire a product, the demand curve shifts to the left.
The following are changes in demand-related factors that affect the quantities demanded at every price along the demand curve:
Consumer preferences: Consumer tastes are constantly changing as new technology comes out or clothing fashions change. For example, the introduction of cell phones eliminated consumer preferences for pagers.
Income of consumers: Changes in consumer incomes will shift the demand curve. For example, consumers with higher incomes are more likely to buy brand-name grocery products instead of generic brands. On the other hand, consumers are more able to purchase a car when they have higher incomes instead of taking the bus, thereby reducing the demand for bus services.
Price of other consumer products-substitutes or complements: Two goods are complements if a price increase in one causes a drop in demand for the other. For example, if computer prices increase, decreasing the demand, consumers will have less need for software; so the demand for software apps will drop. Other examples are eggs and bacon, and bagels and cream cheese; price changes in one product will affect the demand for the other.
Expectations about the future: Expectations about the future affects consumer behavior. If consumers believe that prices for a product will rise in the future, they will purchase more of the product now, shifting the demand curve to the right.
Effect of Supply
Movements along the supply curve are only caused by changes in the price of the good.
The law of supply says that producers will increase output when the price of a good increases. A shortage of supply will drive prices up. Consumers fear that they will not be able to obtain the product, so they are willing to pay more for it.
An excess of supply will cause producers to cut prices to reduce the inventory that is building up in their warehouses.
Factors That Shift the Supply Curve
When a change increases the willingness of manufacturers to offer more of a good at the same price, the supply curve shifts to the right. If the change decreases the willingness of the producer to sell the good at the same price, the supply curve shifts to the left.
Input prices: When the prices of raw materials go up, the profits on certain products go down. As a result, manufacturers will reduce production volume and focus on products with higher profits. The supply curve will shift to the left.
Number of sellers: The supply curve moves to the right when new sellers enter the market. Competition increase as more products become available, putting downward pressure on prices.
Technology: Advances in technology increase productivity in the manufacturing processes, making goods more profitable and shifting the supply curve to the right.
Effects of Elasticity on Prices
Elasticity is another theory of price determination. It is a ratio of how much one variable changes in percentage versus a one percent change in a different variable. In economics, price elasticity is a measure of how much demand changes with an increase or decrease in price.
The formula to calculate price elasticity is as follows:
Elasticity = (percent change in quantity demanded)/(percent change in price)
When a one percent price change results in a greater than one percent change in quantity demanded, the demand curve is elastic.
If a one percent change in price leads to a less than one percent change in demand, the demand curve is considered inelastic.
Let's take a few examples to explain these economic theories in common situations.
Suppose the price of a chocolate bar increased by 10 percent and the demand dropped by 20 percent. The price elasticity would be:
Price elasticity = -20 percent/10 percent = -2
In this case, the price elasticity for a chocolate bar is highly elastic; in other words, demand is very sensitive to changes in prices. Higher absolute numbers indicate more price elasticity.
A few more examples of price elastic products:
Beef: Food products are price elastic when alternate products exist. Price increases of beef will cause consumers to buy more chicken and pork.
Luxury sports cars: Luxury cars are expensive and represent a large portion of a consumer's income. Price increases of high-priced autos will reduce demand unless consumer incomes are going up rapidly.
Airline tickets: Airlines compete fiercely on ticket prices. Consumers have numerous choices to compare prices; they can also choose to travel by train or car where the cost of transportation may be lower.
Consider a product where the demand is inelastic: gasoline. People must have gas to drive to work, go to the grocery store and take the kids to soccer practice. If gas prices go up, consumers will still buy gasoline; they don't have many alternatives, at least in the short term.
Take this example: gas prices increase by 15 percent and demand goes down by 1 percent.
Price elasticity = -1 percent/15 percent = -0.07
Although gasoline prices are inelastic in the short term, higher prices will drive consumers to purchase more fuel-efficient cars in the long term.
A marketer must understand the elasticity dynamics of the products to develop pricing strategies. A mistake in anticipating how the consumer will react to price changes can have devastating results on sales and profits.
Other examples of products with inelastic demand:
Salt: The consumption of salt represents a small portion of the consumer's income, and no good substitutes exist. A price increase in salt will have little effect on demand.
Water: Water is a necessity. If the local water utility raises prices, consumers would have to pay up. Besides, they don't have alternate sources, other than the more expensive bottled water.
Cigarettes: The demand for addictive products is usually inelastic. If governments place more taxes on cigarettes, the demand will not drop appreciably, until taxes become extremely high.
The methods of price determination in economics include the laws of supply and demand, and the effects of price elasticity. Numerous factors enter the economic equations that determine equilibrium prices; marketers have to understand the pricing dynamics in their markets to develop effective pricing strategies.