What it means
At its simplest, the theory says that a price settles where the quantity buyers want equals the quantity sellers offer. If the price is too high, goods pile up unsold and sellers cut prices.
If it is too low, shortages appear and buyers bid prices up. Behind this sits the idea of marginal thinking, which means that buyers and sellers weigh the extra benefit and extra cost of one more unit.
A customer buys another unit only while it is worth more than its price, and a producer supplies another unit only while the price covers the extra cost of making it. The market price is where these decisions meet.
For a manager, the theory explains why pricing power varies between industries. A business selling a product with many close substitutes has little room to raise prices, while one with a unique product can charge more.
The sensitivity of demand to price changes is called elasticity, and it is one of the most practical ideas to come out of the theory. The theory also applies to financial markets, where prices of shares, bonds and currencies reflect the balance of buyers and sellers.
New information shifts expectations, which shifts demand or supply, and the price adjusts quickly. This is the foundation of ideas such as market efficiency.
Real markets rarely match the textbook, because of taxes, regulation, imperfect information and market power. Even so, the theory remains a useful first approximation.
It gives a manager a clear way to ask whether a price change reflects a shift in demand, a shift in supply or both. Cost-based pricing, where a business simply adds a margin to its costs, can look like an alternative to the theory but is really a rule of thumb that works only when the result is close to what the market will bear.
If the cost-plus price is above what customers will pay, sales collapse; if it is below, the business leaves money on the table. Checking a cost-plus price against likely demand is therefore a sensible discipline.
In practice
Real-world examples.
Example
A hotel chain raises room rates during a large conference week when demand surges. Occupancy stays high because the number of rooms is fixed. The chain earns higher revenue per available room without any extra cost.
Example
A farm co-operative sees a bumper harvest push the market price of wheat down. Individual farmers cannot change the price, so they decide whether to store the crop or sell it. The co-operative uses the theory to explain the swing to its members.
Example
A software company tests two price points for a subscription and measures how many customers sign up at each. It finds that the higher price loses very few customers. The company adopts the higher price and records the extra revenue as margin.
Formula
Calculation
Equilibrium: quantity demanded = quantity supplied. Price elasticity of demand = % change in quantity demanded / % change in price.
Suppose a cafe sells 1,000 cups a week at $4.00, and when the price rises to $4.40 it sells 900 cups. The price change is (4.40 - 4.00) / 4.00 = 10%. The quantity change is (900 - 1,000) / 1,000 = -10%. Elasticity = -10% / 10% = -1, so demand is unit elastic. Weekly revenue before the rise was 1,000 x $4.00 = $4,000, and after the rise it is 900 x $4.40 = $3,960, which is slightly lower.Case study
Seen in the real world.
Brightwater Coffee Roasters is an illustrative, fictional business that sold its main blend for $12 a bag and wondered whether to raise the price. The owner asked the finance manager to apply the theory of price using a month of sales data.
The manager ran a short test, raising the price to $13.20 in half of the shops. Sales in those shops fell by 5% while the price rose by 10%, so demand was inelastic, meaning customers were not very sensitive to the change. Revenue per shop rose, and so did the gross margin.
The illustrative conclusion was to adopt the new price, but the manager also noted that elasticity can change over time. She planned to repeat the test each year, because new competitors could make customers more sensitive to price. She also presented the owner with a one-page summary showing the old and new price, the change in volume and the effect on gross profit. Seeing the numbers side by side turned a gut-feel debate into a decision that could be reviewed later.
Watch out
Common mistakes.
- Assuming that raising the price always raises revenue, when elastic demand can cause revenue to fall.
- Confusing a movement along a demand curve, caused by a price change, with a shift of the curve, caused by tastes, income or other factors.
- Believing the market price equals the cost of production, when the theory says price is set by supply and demand together.
Questions
People also ask.
What is the difference between price and value?
Price is what you pay in the market, while value is the benefit you receive, and the theory explains why the two often differ.
Does the theory apply to services and labour?
Yes, wages and fees are prices too, set by the supply of workers and the demand for their skills.
Why do some prices stay fixed for long periods?
Because of contracts, regulation and the costs of changing menus and price lists, which economists call sticky prices. Over time, a fixed price that no longer matches supply and demand produces shortages or surpluses, which is why most such prices are eventually reset.
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