Economic Theory of Price and Its Determination

Price refers to the value of a commodity and services expressed in terms of money. Now we are fixing price for any kind of goods and services. Even consider a labor we fix a price for his service in terms of wage.

Functions of price

In the early time people were used ‘Barter’ system for the exchanging of goods and services. Now almost all the economies are using money for exchanging goods and services. So, money plays a vital role in an economy and many theories were developed in Economics. Price performing numbers of functions in an economy. Some of them are described below.

I) Median of exchange

As said above, the removal of ‘Barter’ system leads to got money value for all things, even consider services.

II) Unit of account

Now, the value of goods and services are measured in terms of money. So, money considered as a unit of measure.

III) Incentive to production

A high price enables incentive to production. Suppose the wage is very high, normally laborers have a tendency to work more or suppose the price of the commodity is high then the firm ready to produce more, because they want more profits.

IV) Signaling mechanism

Suppose the price of a product is high, automatically the consumer have a tendency to consume related complimentary goods (complimentary goods= different goods can be used to satisfy a particular want)

Price determination

In a perfect competitive market price is determined by the interaction point of demand and supply.

Demand curve is inversely related with price (when price increase demand decrease) and supply is directly related with price (when price increase supply also increase)

For simplifying we can explain this with a diagram below. SEE DIAGRAM BELOW

Here consider apple is the commodity. In the diagram consider price ‘P’. at point ‘P’ the quantity demanded equal to the quantity supplied. Here point ‘E’ is the equilibrium point and ‘P’ is the price of the commodity Apple.

Consider price ‘P1’ the demand of Apple is less but the supply is high. This excess supply is known as “excess supply”

Consider price ‘P2’ the demand of apple is more than supply. This excess demand is known as “excess demand”

Since at point ‘E’ the quantity supplied equal to the quantity demanded, ‘E’ is the equilibrium point and ‘P’ is the market determined price.