The price Theory is a microeconomic principle that explains that the price of any specific product is determined through the interaction of demand and supply forces in the market. The price so determined is considered as the equilibrium or the market price of the product.
As per the law of demand, the price of the product and the quantity demanded shows an inverse relationship. The consumers’ intention is to maximize the utility by purchasing more units of the product when the price is low. At a high price, the fewer number of goods will be purchased because a high price reduces the consumers’ real income.
The Law of supply explains the positive relationship between the price of the product and the quantity supplied of the same. The suppliers’ intention is to maximize the profit by supplying more number of units to the market at a higher price. When the price is low, the fewer number of units will be supplied to the market because it reduces the profit per unit.
The price theory explains how the interaction of demand and supply forces with contradictory objectives determine the market price of a product and it can be illustrated by using the following diagram.
As per the above diagram, at the price “P1” the quantity demanded is “Q1” and the quantity supplied is “Q5”. Since the price is comparatively high, the quantity demanded is less,s and the quantity supplied is comparatively high because the profit per unit sold is higher and it increases the suppliers’ profit. As a result, there are some unsold goods or an excess supply (a – b) in the market. The excess supply tends the price of the product down.
Fall in price encourages the consumers to demand more goods with the intention to maximize utility. As per the diagram, at the lower price “P2” quantity demanded increases from Q1 to Q4. When the price falls profit of the suppliers also falls and they reduce the quantity supplied up to Q2 thereby creating an excess demand (c – d) in the market. The excess demand creates competition among the consumers and it will push the price up.
The same interaction will continue and finally, the quantity demanded will become equal to quantity supplied at a particular price “P”. It is termed as the Equilibrium price or the market price. The quantity demanded and supplied at that price is equal and it is called “Equilibrium Quantity”. Once the equilibrium price is determined it will remain in the market unless and until the existing demand and supply conditions change. Both the consumers and the suppliers have accepted the price so determined. When the market is in equilibrium, there is no excess demand or excess supply. There is no any other reason to change the market price.
As the price theory explains, there are situations that the equilibrium price changes with the changes in either demand, supply, or both, as listed below.
- An increase in supply (rightward shift of supply curve) while all the other factors remain constant, decreases the equilibrium price and the quantity.
- A decrease in supply (leftward shift of supply curve) while all the other factors remain constant, decreases the equilibrium price and increases the quantity.
- An increase in demand (rightward shift of demand curve) while all the other factors remain increases the equilibrium price and the quantity.
- Decrease in demand (leftward shift in the demand curve) while all the other factors remain constant, decreases the equilibrium price and the quantity.
- Proportional increase or decrease in both demand and supply do not change the equilibrium price but the quantity will change.
The above situation can further be illustrated by using diagrams as below.
As per the above diagram, the original market equilibrium is at the point “a” at the price “P” and the quantity is “Q”. The demand increases by shifting the demand curve to D1. As a result, a new equilibrium is created at the point “b” increasing both the price and the quantity. When there is a decrease in demand by shifting the demand curve from “D” to D2”, both the equilibrium price and the quantity has come down.
The above diagram shows that the price of the product is determined at the point “a” where the original demand curve “D” intercept the original supply curve “S”. Due to the increase in supply, the demand curve has shifted from “S” to “S1” and the market equilibrium changes from “a” to “B” by reducing the market price and increasing the equilibrium quantity. A decrease in supply has shifted the supply curve from “S” to “S2” by moving the market equilibrium upward from “a” to “c”. As a result, the market price has increased and the quantity traded has come down.