Everything that is sold in the market has a price. Consumers are always interested in the prices as everyone would want to get their preferred product at a cheaper price. Both the consumers and producers are affected by the rise or fall in the amount of any product.
Producers would always want to make some profit out of their product by marking the retail price higher than the input they have invested. The theory that determines the hike or fall of prices in the market and the reason behind it, is known as the price theory.
In this article, we will discuss all the aspects of price theory.
What is Price Theory?
Investopedia explains that the price theory is an economic theory that claims that the price of any commodity or service is determined by the supply and demand connection. According to this theory, the most optimum market price for an item or service is where the benefit earned from those who desire the thing matches the seller's marginal costs.
[If you are wondering what is supply and demand, The law of supply and demand is a theory that describes how sellers of a resource interact with buyers of that resource. The idea describes the link between a good's or product's price and people's willingness to buy or sell it. People are often inclined to supply more and demand less when prices rise, and vice versa as prices fall.]
Coming back to the price theory, this theory is also known as a “Microeconomic principle”.
[Microeconomics is a social science that investigates the consequences of incentives and actions, particularly how they impact resource usage and distribution. It demonstrates how and why various things have varying values, how individuals and corporations conduct and profit from efficient production and exchange, and how people may effectively coordinate and cooperate.]
It gets its name from the fact that it employs the supply and demand principle to establish the optimum pricing point for a specific commodity or service.
The objective is to reach a state of equilibrium in which the amount of products or services given corresponds to the demand of the relevant market and its ability to obtain the commodity or service. Price theory is a notion that allows for price changes when market conditions change.
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Determining the price:
The three major pillars of pricing strategy are cost and profit objectives, customer demand, and competition. The major goal is to persuade clients that this product is indeed worth its price.
To determine to price, sum all of the costs together and deduct any other sources of revenue: this is the minimum profit you'll need to break even, thus this is the starting point.
To calculate the maximum selling price, think about both clients and the demand for their goods. Now that a pricing range has been established, apply profit targets and competitor information to determine the ideal price. In principle, the notion is simple, but in practice, one must account for market factors and undercutting competition. Constant adjusting and monitoring are required to strike a balance between competitive prices and maximum revenue.
There are 4 methods to determine the price of products, according to this article written by Chron.
Pricing based on theory:
Cost-based, demand-based, or competition-based pricing are all options. In cost-based pricing, we establish prices only based on production costs and targeted profit, disregarding demand.
Consumer research aids in determining an acceptable price range in demand-based pricing, after which you may establish profit and expense needs within that range.
Sellers establish their rates depending on the rivals in competition-based pricing. They may be selling at, above, or below-market pricing depending on consumer loyalty or brand variations.
Pricing based on advantageous situation:
When the producer has a significant competitive advantage, such as the ability to charge a high price for uniqueness, use premium pricing.
Try penetration pricing when you're new to a market and need to establish client loyalty: lower your rates to obtain market share and then raise them later.
Skimming, the polar opposite of penetration pricing, allows you to generate more money upfront and then cut prices later to stay competitive. Economy pricing is simple: keep your costs low so you can keep your prices low while still making a profit.
Pricing based on Psychology:
Setting the price in such a way that clients have a good emotional response is known as psychological pricing. It's all a matter of perspective, and buyers frequently see unusual pricing values as more appealing or cheaper than they are.
Pricing based on Product Orientation:
We can adjust the pricing approach if we have certain product associations. Adding optional extras, such as airline fees for excess luggage or bundling items, conceals the exact cost from your customer.
When a product has a companion, such as a razor and blades, one may keep the price of the initial purchase (razor) low and recoup the expenditures with the subsequent purchase (blades) (unique blades).
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How does price theory affect market competition?
There are 4 types of market competitions that we must be aware of:
The term "perfect competition" refers to a market system in which competition is at its most intense. The interaction of market forces Demand and Supply determines the price of a commodity. When Market Demand equals Supply, we have an equilibrium price.
When one person or company is the exclusive supplier of a certain commodity in the market, it is called a monopoly. Each of the following elements would normally be present for a real monopoly to exist: A viable product or service's single provider. There are no close replacements available for consumers to pick from. High hurdles to entry to discourage any possible rivals.
It's a market condition in which a big number of companies sell items that are similar but not identical. The result of combining perfect competition with monopoly. Because a large number of vendors provide diverse or varied items and customers have preferences for certain suppliers, there is imperfect competition.
An oligopoly is a market structure in which a few numbers of Big vendors control a market or sector. Oligopolies can arise as a result of many types of collusion, which reduces competition and raises consumer costs.
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Price determination and discrimination in monopoly market:
A monopolist's goal is to maximize profits. He will take advantage of the circumstance and try to make the most money possible as the lone seller in the market. For all those who desire the good should purchase it from him alone. They don't have any other options.
A monopolist will be led by just one incentive when establishing the price of a commodity: to maximize his earnings. Monopolies are defined by a lack of economic rivalry in the production of the good or service, as well as a lack of feasible substitutes.
It is sometimes conceivable and lucrative for a monopolist to charge different prices to different purchasers for the same commodity. For example, a doctor may charge a rich guy more for the same procedure than a poor man.
Only when there is no potential of resale from one customer to another is price discrimination feasible. That is, consumers should not be able to acquire things on a lower market and sell them on a more expensive market. (here)
Limitations of Price Theory:
The limitations of price theory are given below:
It only gives a theoretical analysis of how the various components of the economy function. However, the operation of separate pieces does not provide a whole picture of how the economy works. Price theory cannot do credit to the complexity of each economic unit, which necessitates minute description and investigation.
It just provides guidelines based on the information provided. The data is frequently unreliable. It is based on a guess, which may turn out to be incorrect.
Even the premise of rationality upon which decision-making is founded to make the most effective use of limited resources is rarely observed by businesspeople and customers. Nonetheless, the assumption of reason aids in the efficient use of finite resources.
Price theory may not be able to describe the actual world since it is based on limited data and unrealistic assumptions, but it can provide insight into how the economy works if we focus on the most relevant facts.
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Let us conclude this blog with an example, Apple, Inc. provides a variety of MacBook Pro models, each with its own set of features and costs. Each laptop computer is also available in several colours for the same price.
According to the study, the optimal pricing policy is to use the same price for all goods in a product range. For example, if Apple charged a greater price for a silver MacBook Pro than for a space grey MacBook Pro, demand for the silver model would decline and supply would rise. Apple may be obliged to lower the price of that device at that moment.
This is what price theory is all about. In this blog, we have learned what price theory is, how we can determine the price of any product, how it affects market competition, and what are its limitations.
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