If you answered Price = Cost of manufacturing + profit, uh-oh, try again!
Price is determined by 'Supply and Demand' - an economic model which operates more like an auction house than anything formulaic. A giant extrapolation of 'Ebay' into a global market of sellers and buyers whose point of agreement is the equilibrium price at which goods are traded.
Let us keep the focus on Price and Quantity as we step through some principles.
1. Law of Demand:
Assuming there are no other constraints, when price increases, the quantity of demand decreases.
Example: What is the demand for a can of Coke? If I have a budget of $ 10 to spend on soft drinks every week. I can buy ten cans of Coke @ $ 1 or five cans of Coke @ $ 2.
Factors that can affect the law of demand are
- Increase in income/ wealth ( If my income increases and my weekly allowance increases, I might still buy 10 cans of Coke @ $1.20 instead of reducing my consumption)
- Availability of substitutes ( If I find Dr. Pepper/ Lemonade/Water at the same or lower price, I might switch to a new product, thereby reducing my consumption and thereby demand for Coke)
- Increase in population increases demand
- Market place trends such as move towards healthier food habits will decrease demand for Coke
- Stockpiling for the future. When there is an expectation, or even rumors for that matter (of a storm or an increase in price or reduction in supply), people start stockpiling and we see empty store shelves i.e. increase in demand
2. Law of Supply:
This works in the opposite direction as the law of demand. When price increases, the quantity of supply also increases.
Factors that can affect the law of supply are
- Decrease in production costs ( moving to China, new improved technology, etc..), increases profits, which will prompt suppliers to increase the supply
- Increase in number of suppliers ( if the product is profitable, more firms will try to get into the business and thereby increase the supply
- Natural events like hurricane disrupt production / transportation capabilities and thereby decrease supplies
- Expectations ( or rumors) of any event that will increase the price in the future, will cause a reduction in supplies. Suppliers stockpile to sell at a later date when the price will be higher
3. Free market equilibrium
In a free market, the price of a product will adjust to a point when supply and demand are at equilibrium ( rest).
- If the price is too low, supply will reduce and demand will increase to a state of excess demand, which will then drive up the price to its equilibrium
- If the price is too high, demand will fall and excess supplies will drive the price down.
But then there is no permanent equilibrium either, as the various factors that affect the laws of supply and demand change, we reach new points of equilibrium. As manufacturing moved to China, we saw prices dropping on manufactured goods. We are now seeing the price shift for Apple products as demand increases, as the economy splutters and as formidable competitors emerge. And so it goes.
Back to Blog:
Can we have some gasoline, please
Other topics:
The Price of Oil
Global Gas Consumption and Prices
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