<Last updated 13.04.2020>
Hi! If you are interested in Economics, I’ve prepared the below to help your understanding of price determination. You should take a look at this short article in which I explain how Demand for goods and services is formed and how Prices are determined by Aggregate Demand and Supply .
Scarcity of resources, and so scarcity of goods and services provided, leads to the setup of a price system. In a Free Market or Mixed Economy system, price is determined by Supply and Demand for the Good. Demand is formed by the Buyers (preferences for consumer goods) and Supply is formed by sellers (producers).
Consumers want to maximize their utility, given a fixed income amount, demanding-buying goods and services, while producers want to maximize their profits by providing, selling, goods and services. In the following theoretical model we show how Demand curve is formed. It is the relationship between price and quantity demanded, at each price level the quantity demanded is different (for a specific period). The quantities demanded must be from buyers that have the desire and can (afford to) buy.
This relationship, of course describes the preferences of rational individuals, who prefers to buy less quantity of the good when the price, the cost that is, is higher. Law of Demand: With other factors affecting quantity demanded equal (ceteris paribus), there is a negative relationship between price and quantity demanded.
Individual and Total Demand Curve is shown assuming that there are only two consumers interested for normal goods: Andreas, depending on his own unique preferences, has an individual demand curve for goods and services. Same applies for George. Important to note that his curve is different from the other’s because he is reacting differently to changes in prices, and that of course is determined by his own preferences. We add up all quantities demanded at each specific price level. Adding up the two gives us the Aggregate/Total Demand for goods and services.
When price increases quantity demanded is less. When price decreases, quantity demanded is more. This is the consumer’s response to price change in this example and is explained by two reasons-effects:
> Substitution effect: When the price of Good A falls, while prices of other goods (that can be used to satisfy same needs) stays the same, the quantity demanded for good A increases (i.e. oranges vs apples).
> Income effect: When price falls, the consumer can buy more quantity compared to the case before the price change. Leads to an increase of real income. (Real Income: Income/price)
What makes people demand more or less quantities of goods if price is not the cause? The most important factors affecting consumer demand are:
a) Consumer income: When income increases, demand for consumer goods increases, for most goods called normal goods.
b) Prices of other goods (substitutes): Substitutes are the goods that can be used to satisfy almost the same need. i.e. instead of sugar, buy sweeteners.
c) Supplements: Supplements are the goods that have to be consumed together to satisfy a need. i.e. hardware can be sold only with software. The phone device is hardware, the apps are software.
d) Consumer preferences: Consumer preferences are affected by many factors such as culture, customs, advertisement, fashion, temperature (summer mood > ice cream demand) etc.
e) Consumer expectations: Consumer expectations play a vital role in decision making. Relates to what kind of information they have. Expectations about their future income, about the future prices of goods and services etc.
f) Population: Total Demand for a product, good, depends on the number of buyers available. The more the population, the more the needs, the more the demand.
g) Population demographics: by gender or age. As higher the percentage of the population belonging in the group of people buying the products of concern.
All the previous factors cause a shift of the demand curve (line in this case).
Some factors shifting demand for a good to the right (increase):
-Increase in consumer income.
-Consumer preferences shift towards preferring that good.
-Consumer expectations of increase in their future income.
Equilibrium exists when the price balances Supply and Demand, a level where no one, buyer or seller, wants to deviate from that level. The fllowing graph shows also Supply and how these two forces together determine the price level and how they can affect it.
The equilibrium price is the price at which quantity demanded equals quantity supplied (EP).
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