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PRICE THEORY IN e
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ECONOMICS r
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BANOGON, C.L. s
 ORIGIN OF VALUE AND PRICES

Price theory is concerned with explaining

economic activity in terms of the creation
and transfer of value, which includes the
trade of goods and services between
different economic agents. A puzzling
question addressed by price theory is, for
example: why is water so cheap and
diamonds are so expensive, even though
water is critical for survival and diamonds are
not?
 ORIGIN OF VALUE AND PRICES

In a discussion of this well-known ‘Diamond-Water

Paradox,’ Adam Smith (1776) observes that
the word value, it is to be observed, has two
different meanings, and sometimes expresses the
utility of some particular object, and sometimes the
power of purchasing other goods which the
possession of that object conveys. The one may be
called “value in use;” the other, “value in exchange.”

For him, diamonds and other precious stones derive

their value from their relative scarcity and the
intensity of labor required to extract them.
 ORIGIN OF VALUE AND PRICES

Labor therefore forms the basic unit of the

exchange value of goods (or ‘items’), which
determines therefore their ‘real prices.’ The
‘nominal price’ of an item in Smith’s view is
connected to the value of the currency used
to trade it and might therefore fluctuate. In
this labor theory of value the Diamond-Water
Paradox is resolved by noting that it is much
more difficult, in terms of labor, to acquire
one kilogram of diamonds than one kilogram
of water.
WHAT IS THE 'THEORY OF PRICE'

The theory of price is an economic theory that

contends that the price for any specific good/service
is based on the relationship between the forces of
supply and demand . The theory of price says that
the point at which the benefit gained from those who
demand the entity meets the seller's marginal costs is
the most optimal market price for the good/service.
 WHAT IS THE 'THEORY OF PRICE'

• The theory of price, also known as price theory, is

a microeconomics principle that involves the analysis of
supply and demand in determining an appropriate price point
for a good or service. The goal is to achieve equilibrium in
which the quantities of goods or services provided match the
corresponding market's desire and ability to acquire the good
or service. This concept allows for price adjustments as market
conditions change.
• For example, suppose that market forces determine that it
costs P5 for a coco bread. This suggests that coco bread
buyers are willing to forgo the utility in P5 in order to possess
the coco bread and that the coco bread seller perceives that
P5 is a fair price in exchange for giving up the coco bread.
This simple theory of determining prices is one of the core
principles underlying economic theory.
PRICE TAKING BEHAVIOR AND CHOICE

1. ) Rational Preferences
Rational choice theory is an economic principle that
states that individuals always make prudent and logical
decisions. These decisions provide people with the
greatest benefit or satisfaction — given the choices
available — and are also in their highest self-interest.

2. ) Utility Maximization
Microeconomic concept that, when making
a purchase decision, a consumer attempts to get the
greatest value possible from expenditure of least amount
of money. His or her objective is to maximize the total
value derived from the available money.
PRICE TAKING BEHAVIOR AND CHOICE

3. ) Comparative Statics
Comparative statics is a tool used to predict
the effects of exogenous variables on market
outcomes. By exogenous variables, we mean
anything that shifts either the market demand curve
(for example, news about the health effects of
consuming a product) or the market supply curve (for
example, weather effects on a crop). By market
outcomes, we mean the equilibrium price and the
equilibrium quantity in a market. Comparative statics
is a comparison of the market equilibrium before and
after a change in an exogenous variable.
PRICE DETERMINATION IN ECONOMIC
THEORY
In general, the price can be influenced strategically
by agents who have “market power.”
• Demand - The amounts of a firm’s product that
consumers will purchase at different prices during a
specified time period
• Supply - The amounts of a good or service that will
be offered for sale at different prices during a
specified period
• Pure competition - Market structure with so many
buyers and sellers that no single participant can
significantly influence price
PRICE DETERMINATION IN ECONOMIC
THEORY
• Monopolistic competition - Diverse parties
exchange heterogeneous, relatively well-
differentiated products, giving marketers some
control over prices
• Oligopoly - Relatively few sellers; each has large
influence on price
• Monopoly - Only one seller of a product exists and
for which there are no close substitutes
DISTINGUISHING FEATURES OF THE
FOUR MARKET STRUCTURES
 COST AND REVENUE CURVES

• A product’s total cost is composed of

total variable costs and total fixed
costs
• Variable costs - Change with the level of
production
• Raw materials and labor costs
• Fixed costs - Remain stable at any
production level within a certain range
• Lease payments or insurance costs
 THE CONCEPT OF ELASTICITY IN
PRICING STRATEGY

• Elasticity - Measure of responsiveness

of purchasers and suppliers to a
change in price
• Elasticity of demand
• Elasticity of supply
• Inelastic
 DETERMINANTS OF ELASTICITY

• Availability of substitutes or complements

• Role as a complement to another product
• Number of business transactions conducted online
• Whether product is perceived as a necessity or
luxury
• Portion of a person’s budget spent on an item
• Demand shows less elasticity in the short run than
in the long run
PRICE DETERMINATION IN PRACTICE

• Cost-plus pricing - Uses a base-cost figure per unit

and adds a markup to cover unassigned costs and
to provide a profit
• Allows businesses with low costs to set prices lower
than those of competitors’ and still make a profit
ALTERNATIVE PRICING PROCEDURES

• Full-cost pricing
• Uses all relevant variable costs in setting a
product’s price
• Allocates the fixed costs not directly attributed to
the production of the priced item
• No consideration of competition or demand for the
item
• Any method for allocating overhead is arbitrary and
may be unrealistic
ALTERNATIVE PRICING PROCEDURES

• Incremental-cost pricing - Attempts to use only

costs directly attributable to a specific output in
setting prices

Sales (10,000 units at P 10) P100,000

Expenses:
Variable P50,000
Fixed 40,000 90,000
Net Profit P 10,000
 GLOBAL ISSUES IN PRICE
DETERMINATION

• Prices must support the company’s broader

goals
• Domestic pricing strategies:
• Profitability
• Volume
• Meeting competition
• Prestige
• Price stability