LECTURE TWO
2.1.0 Price Theory
This is concerned with the study of prices and is regarded as the basis of economic theory. The
chapter will look at different concepts, which relate to price, prices and their determinants, and
uses of prices in different fields of economics.
2.1.1 Price
Price is the exchange value of a commodity in terms of money. It is the amount of money that has
to be paid for a specific quantity of a commodity. In practice, it is the amount of money that will
purchase a definite weight and measure of a commodity. Price may be classified into; equilibrium
price, market price, reserve ( or reservation) price and normal price.
2.1.1a. normative (ideal) price
This is the price that regulates the flow of production and consumption so that they stand at an
equilibrium position. It is an ideal price, which may never be realized, and the market price tends
to oscillate around it. Only reproducible goods have normal prices.
2.1.1b. Equilibrium price
This is the price at which the quantity supplied equals the quantity demanded. It is determined by
the intersection of market forces of demand and supply. i.e. it is fixed or set at the point of
intersection of demand and supply curves and it rules in a free enterprise system (see diagram
below)
Pe is the equilibrium price and Qe is the quantity price
2.1.1c. Market price
This is the ruling (prevailing) market price for a given product in the market. It may or may not
necessarily be the equilibrium price since it is determined by a number of factors.
Determinants of market price
1. Haggling (bargaining)
This is a system whereby few (prospective) buyer(s) and the seller approach each other and
determine the price between two stated limits.
2. Sales by Auction
In this case there is one seller and so many prospective buyers. The auctioneer puts up an article
for sale and asks for bids (offer of prices) for it. Any one who is desirous of purchasing is then at
liberty to offer his own price. The buyer, who is prepared to pay the highest price, will eventually
buy the article.
3. Forces of demand and supply
This applies for transactions in a free market situation whereby price is set or determined by the
interplay of forces of demand and supply. The point of intersection of the two curves is where the
price level is reconciled.
4. The government policy of price legislation
The government normally intervenes in a free market situation or the private sector of a mixed
economy by fixing price either above or the equilibrium price. If government sets the price above
equilibrium, the price set is known as minimum price-below, which it is illegal to sell.
Maximum price is however set below the equilibrium price and it is illegal to sell above it (see
illustration below)
The minimum price is also referred to as the price floor of guaranteed or an intervention price
while the maximum price is also known as the price ceiling.
Reasons for setting a maximum price
i. To protect weak (primary) producers from exploitation by strong buyers.
ii. An inducement for mass production. It is set to accelerate production.
iii. A price incentive (investment incentive) to potential producers especially the primary
producers. It helps attract new investors.
iv. To control price fluctuations and therefore make an economy attain price stability.
v. Means of offsetting an economic recession or a depression. Minimum prices tend to activate
investments or production in an economy.
vi. It minimizes exploitation of labor as in the case of minimum wages.
vii. Minimum prices are set to discourage the consumption of certain commodities.
viii. It is set to encourage creativity and innovativeness in production.
ix. Minimum prices, more especially on foreign products, are set to reduce their importation and
thus correct any imbalance in the balance of payments.
Effects of minimum price legislation
i. Surplus results because of excess production.
ii. Problems of storage arise more especially in LDC’s where there are limited storage facilities.
iii. It encourages price increase hence inflationary tendencies.
iv. Consumption reduces as many people find it difficult to afford the goods whose prices have
been legislated.
v. Labor unrest is reduced- the case with minimum wage legislation.
vi. Effort and initiative at work are encouraged hence increased participation in productive
activities.
vii. Excess capacity is reduced as some idle potential are not put to use.
viii. Earnings of (primary) producers and labor increase. This may result into increased investment.
Reasons for setting maximum price
i. To protect consumers from exploitation by profit-minded traders and some producers.
ii. To check or regulate monopoly tendencies, as monopoly to a greater extent is a price maker.
iii. To encourage the consumption of some selected goods most especially merit goods.
iv. To discourage production of some commodities most especially those which are undesirable
to our health and morals e.g. demerit goods and public goods.
v. To minimize unnecessary price hikes (inflation).
Effects of price ceiling
i. Shortages of commodities result since the legislated prices tend to be less attractive to
producers.
ii. Mal-practices developed in the market and these include: hoarding, smuggling, e.t.c
iii. Rationing of commodities become the order of the day and thus the effects.
iv. Excess capacity occurs, as a number of resources are not put into use.
v. Entrepreneurship is discouraged as profit margin reduces.
vi. Unemployment and under employment result as firms try to reduce their costs.
vii. Deflation may arise and this, if not checked, may lead to economic depression.
5. Sales through treaty
The market price may be set through agreements or treaties say by, the information of a cartel (e.g.
OPEC) or a commodity agreement (e.g. International Coffee Agreement)
6. Offers at fixed prices
This is done mainly by monopolies who, unless interrupted by government, have sole authority to
manipulate market price to the disfavor of the public.
7. Oligopolistic price determination
This is by way of price leadership whereby either the dominant or the low cost firm sets prices for
others to follow.
8. Resale price maintenance system
In this case the producer of the product sets the price at which the item should be sold to the final
consumers. It is common with goods such as news papers, magazines, catalogues e.t.c
Reserve price
This is the price below which a seller is not willing to sell his product. It is the lowest or least
possible acceptable price a seller can sell his product. Reservation (reserve) price is determined by
a number of factors discussed below.
Determinants of reserve price
i. Future demand: The higher the future demand the higher the reserve price and the lower the
future demand the lower the reserve price of a commodity in question.
ii. Future cost of production: The higher the future cost of production, the lower the reserve price
and the lower the future cost of cost production, the higher the reserve price. This is so because
producers would prefer to produce and sell more when production cost is low.
iii. Durability or perishability of goods. Durable goods have higher reserve price and perishable
goods have relatively low reserve price.
iv. Anticipated length of time when the goods will be stored before sale at anticipated future price:
The longer the anticipated time period, the higher the reserve price and the shorter the
anticipated time period, the lower the reserve price.
v. The length of time it will take before the new supply of goods reaches the market: The longer
the time period the higher the reserve price and the shorter the time period the lower the reserve
price of the commodity in question.
vi. Storage or carrying charges in relation to future price: The higher the storage or holding cost,
the lower the reserve price and the cheaper it is to hold the goods, the higher the reservation
price.
vii. Cash flow requirements: The need for liquid capital in a business. The greater the need for cash
in a business the lower would be the reserve prices of the firms product(s) and the lesser the
need for money in a business, the higher the reserve prices.
N.B The most economical way of determining market price is by demand and supply of goods and
services produced and this is why we shall deal in details with the concepts of demand and supply
under the price system.
