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What Is the Theory of Price?

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  • Written By: Osmand Vitez
  • Edited By: Kristen Osborne
  • Last Modified Date: 09 July 2014
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The theory of price is an economic concept that defines how or why a consumer will purchase a good or service from a particular company. In order for this transaction to occur, both the company and consumer must agree on the item’s price, which is inherently linked to the product’s value. Price and value are two important factors for the movement of goods or services in the economic marketplace. The theory of price can also include external factors, such as the number of competing products, aggregate demand from consumers and the size of the overall economic market.

In a free market economy, economists typically explain the theory of price using a basic supply and demand chart. This chart helps companies understand at what price point they will sell the most goods or services, thereby maximizing their financial returns. On a right angle graph, the horizontal line represents price and the vertical represents quantity. The supply curve starts from the lower left corner and slopes upward to the right. The demand curve starts in the upper left corner and slopes down and to the right. The intersection of these lines is known as the equilibrium point, where companies and consumer will agree on product price.

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The supply and demand chart indicates that under the theory of price, companies are more willing to increase supply at higher prices because profits are higher. However, consumers are typically not willing to pay high prices for goods they deem to have little to no value. Conversely, demand is high when prices are low, although some companies are not willing to sell many goods of this nature because of low profit.

The number of competing products in the economic market can affect the theory or price. Competing companies will attempt to undersell other companies by offering similar goods at a lower price, which in turn will shift the equilibrium price point for goods and services. Companies offering inferior or substitute products can also shift the market away from a name brand product.

Consumer demand and the size of the overall economic market also influence the theory of price. Consumers unwilling to purchase a good or service will force companies to lower the item’s price until consumers deem it valuable enough to purchase at a specific price point. For example, a company making pots may find that consumers are more interested in pans. Having too many pots for sale at a high price will typically result in fewer or no sales for the company. The company must lower the price of their pots to a point where consumers are willing to purchase them and attempt to rethink their production strategy.

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