PRICE THEORY

Price theory is a microeconomics principle that involves the analysis of demand and supply in determining an appropriate price point for a good or service.

This section is concerned with the study of prices and it forms the basis of economic theory.

PRICE DEFINITION

Price is the exchange value of a commodity expressed in monetary terms.

OR

Price is the monetary value of a good or service.

For example the price of a mobile phone may be shs. 84,000/=.

PRICE DETERMINATION

Prices can be determined in different ways and these include;

1.     Bargaining/ haggling.

This involves the buyer negotiating with the seller until they reach an agreeable price. The seller starts with a higher price and the buyer starts with a lower price. During bargaining, the seller keeps on reducing the price and the buyer keeps on increasing until they agree on the same price.

2.     Auctioning/ bidding

This involves prospective buyers competing to buy a commodity through offering bids. The commodity is usually taken by the highest bidder.

This method is common in fundraising especially in churches, disposal of public and company assets and sell of articles that sellers deem are treasured by the public.

Note that the price arising out of an auction does not reflect the true value of the commodity.

3.     Market forces of demand and supply.

In this case, the price is determined at the point of intersection of the market forces of demand and supply. This is common in a free enterprise economy. The price set is called the equilibrium price.

4.     Fixing price by treaty/ agreement.

This involves the buyer sitting with the seller to negotiate and fix the price at which a good or service shall be sold and the price remains fixed. The price agreed upon at the time of signing the agreement can be changed or revived by amending the treaty. For example hire purchase and deferred payments agreement, rental agreements, land purchase agreements

5.     Price leadership

This is the setting of price by either a leader firm or low cost firm in the industry and other firms follow by charging the same price. This form of price determination is common in oligopolistic firms.

Price leadership takes on the following forms;

-         Dominant price leadership

-         Barometric price leadership

-         Aggressive or exploitative price leadership

6.     Price legislation/ control/ administration.

This is where the government fixes prices of commodities that is either a maximum price to protect consumers or a minimum price to protect producers.

7.     Offers at fixed prices

This is where individuals, government and institutions set the price at which a commodity is to be sold and whoever is to buy from them must pay the fixed price. For example UNEB fixes prices for its examinations, UMEME for a unit of electricity, NWSC for a litre of piped water, in super markets.

8.     Collusion.

This involves sellers agreeing on the price to charge the buyers. It is common when there are few sellers who wish to reduce competition among them and avoid price wars.

For example different operators of bus services can collude or agree to charge a uniform transport fare from passengers on given routes along which their buses operate.

9.     Resale price maintenance.

This is a mechanism of price determination where manufacturers set the prices at which their commodities are to be sold to the final consumers by retailers. The price is usually written on the commodity. In Uganda, resale price maintenance is practiced by;

v Post office on stamps

v The press industry on newspapers

v The telecommunication network industry on airtime cards, simpacks and phones on promotion.

MERITS OF RESALE PRICE MAINTENACE

1.     Ensures price stability in the market.

2.     Stabilises income and profits of retailers

3.     Protects small retailers from being outcompeted by large scale retailers.

4.     Saves time which would have been spent on bargaining.

5.     Enables producers to easily calculate their revenue from sales.

6.     Reduces consumer exploitation in form of increased prices by sellers/ retailers.

7.     Facilitates the collection of taxes by government because prices are stable.

8.     Enables consumers to make consumption plans/ budgets.

CLASSIFICATION OF PRICE

Price may be classified into;

a)     Market price

This is the ruling/ prevailing price in the market at a particular time determined by buyers and sellers. This price changes from time to time since it is determined by a number of factors.

b)    Equilibrium price

This is the price at which quantity demanded is equal to quantity supplied in the market.

The equilibrium quantity and price are got at the point of intersection of the demand and supply forces.

Illustration

OP_e is the equilibrium price.

a)     Normal price

Is the price attained/ obtained when quantity demanded equals quantity supplied in the long run.

OR

This is the long run equilibrium price that persists in the market when supply and demand conditions have settled. It is an ideal price which may never be realized and the market price tends to oscillate around it.

b)    Reserve/ reservation price.

Is the least/ minimum/ lowest price a producer/ seller is willing to accept in exchange of his/ her commodity below which he/ she retains the commodity.

DETERMINANTS OF RESERVE PRICE

1.     Expected future demand for a commodity.

A producer who expects demand for his commodities to increase in the nearby future sets a high reserve price to retain many goods for sell in the future when demand increases while a producer who expects demand for his commodities to fall in the nearby future sets a low reserve price currently so as to sell off the commodity very fast before demand falls.

2.     Expected future price of the commodity.

A seller who expects the future price of the commodity to increase sets a high reserve price so as to retain many goods for sell at a higher price in the future. However, sellers expecting reductions in future prices set low reserve prices such that they sell more currently and avoid the lower prices in the future.

3.     Nature of the commodity (perishable goods vs durable goods)

A seller dealing in durable goods sets a high reserve price because his goods are long lasting and can remain in good condition even when not bought urgently. However, a seller who deals in perishable goods sets a low reserve price to sell off the goods before they go bad.

4.     Degree of necessity of the commodity.

Sellers dealing in commodities with a high degree of necessity set high reserve prices because they know that consumers cannot do without them. However, sellers dealing in commodities with a low degree of necessity set low reserve prices because they know that consumers can do without them.

5.     Size of transport (carriage) and storage charges.

High storage and transport charges lead to a low reserve price because the seller wishes to sell off the commodity very fast before incurring more of these charges. However, low transport and storage charges lead to a high reserve price because the seller is not scared of transporting or storing goods for a long period of time.

6.     The length of the gestation period

A long gestation period leads to a high reserve price because the producer is aware of the inconveniences he/ she is going to go through to produce the next commodities. However, a short gestation period implies that the seller needs less time to produce the commodity and therefore he sets a low reserve price.

7.     Level of liquidity preference of the producer/seller.

Sellers with urgent need for cash (high liquidity preference) set low reserve prices to ensure that they actually sell the goods for the money they need. However, sellers with no urgent need for cash (low liquidity preference) set high reserve prices.

8.     The cost of production.

Producers who incur high costs of production set high reserve prices because it is expensive for them to replace the sold goods. However, producers who incur low costs of production set low reserve prices because it is cheap for them to replace the sold goods.

NB

1.      Gestation period is the time it takes before new supplies of goods reaches the market for example maize takes 3-4 months while mushrooms take 1 month.

2.     Liquidity preference (demand for money) is the desire by individuals to hold assets/ wealth in cash form or near cash form (rather than investing it).

ASSIGNMENT

Explain the factors that lead to high reserve price.

FACTORS THAT INFLUENCE PRICING OF GOODS AND SERVICES

1.     Forces of demand and supply.

As supply exceeds demand, low prices are set due to a surplus of commodities on the market. However when demand exceeds supply, high prices are set for commodities because they are scarce.

2.     Aim/ objective of the producer.

Where producers aim at profit maximization, they restrict output charge a high price and where producers aim at sales maximization, they charge relatively lower prices to encourage people to buy as much quantities as possible.

3.     Cost of production.

High cost of production leads to a high price set since producers aim at profit maximization and low cost of production leads to a low price set for the commodity.

4.     Rate of taxation.

Heavy taxes imposed on goods and services lead to high prices set since producers tend to shift the burden of paying taxes to consumers in form of increased prices. However, low taxes imposed on goods and services lead to low prices set.

5.     Quality of the commodity.

High quality goods are highly priced since producers incur high costs in producing them while low quality goods are lowly priced as they are cheap to produce.

6.     Elasticity of demand for a commodity.

Producers set high prices for commodities whose demand is price inelastic since people continue to buy even if prices increase and they set low prices for those whose demand is price elastic since any slight increase in price results a big fall in quantity demanded.

USES OF PRICE IN A MARKET ECONOMY

·        It is used to determine what to produce.

·        It is used to determine how to produce.

·        It is used to determine where to produce.

·        It is used to determine for whom to produce

·        It is used to determine when to produce.

·        It is used to determined how much to produce.

·        It is used to determine the value of a good.

THE MARKET CONCEPT

A market is a mechanism in which buyers and sellers come into contact and exchange goods and services.

A market where goods and services are traded is known as a commodity market.

FEATURES OF A MARKET

ü There should be sellers

ü There should be buyers

ü There should be an interaction between sellers and buyers.

ü There should be a commodity to be exchanged.

ü There should be an established medium of exchange.