Questions: Essay

(a)

Every individual is interested in prices; and rightly so. Everyone whether he is a consumer or a producer is affected by rise or fall in prices. A consumer is anxious to find out whether the goods he wants to buy have become cheaper or dearer. Similarly, producer is interested in whether the prices of the products he produces and the inputs he uses, have gone up or down. Oscar Wilde once remarked – “An economist is someone who knows the price of everything and the value of nothing.” This observation may not be true at all. But economists right from Adam Smith, Marx, Jevons and Marshall to Joan Robinson, Chamberlin and Hicks have been engaged in explaining how prices are determined and why and when they are high or low. This is the Subject matter of price theory.

Price theory, also known as microeconomics, is concerned with the economic behaviour or individual consumers, producers, and resource owners. It explains the production, allocation, consumption and pricing of goods and services. Price theory, as defined by Prof. Leftwich, “is concerned with the flow of goods and services from business firms to consumers, the composition of the flow, and the evaluation or pricing of the component parts of the flow. It is concerned, too, with the flow of productive resources (or their services) from resource owners to business firms, with their evaluation, and with their allocation among alternative uses.”

Relationship of Supply and Demand to Price Theory

Supply denotes the number of products or services that the market can provide. This includes both tangible goods, such as automobiles, and intangible goods, such as the ability to make an appointment with a skilled service provider. In each instance, the available supply is finite in nature. There are only a certain number of automobiles available and only a certain number of appointments available at any given time. Demand applies to the market’s desire for tangible or intangible goods. At any time, there is also only a finite number of potential consumers available. Demand may fluctuate depending on a variety of factors, like whether an improved version of a product is available or if a service is no longer needed. Demand can also be impacted by an item's perceived value by the consumer market. Equilibrium occurs when the total number of items available—the supply—is consumed by potential customers. If a price is too high, customers may avoid the goods or services. This would result in excess supply. In contrast, if a price is too low, demand may significantly outweigh the available supply. Economists use price theory to find the selling price that brings supply and demand as close to the equilibrium as possible. Firms often differentiate their product lines vertically, rather than horizontally, considering consumers' differential willingness to pay for quality. According to an article published in Marketing Science with research by Michaela Draganska of Drexel University and Dipak C. Jain of INSEAD, many firms offer products that vary in characteristics, such as color or flavor, but do not vary in quality.

For example, Apple, Inc. offers different MacBook Pro models with varying prices and capabilities. Each laptop computer also comes in a variety of colors that are the same price. The study found that using uniform prices for all products in a product line is the best pricing policy. For example, if Apple charged a higher price for a silver MacBook Pro versus a space gray MacBook Pro, demand for the silver model might fall, and the supply of the silver model would increase. At that point, Apple might be forced to reduce the price of that model.

CONCLUTION

I argue that there exists a coherent and relevant tradition in economic thought that I label "price theory." I define it as neoclassical microeconomic analysis that reduces rich and often incompletely specified models into "prices" (approximately) sufficient to characterize solutions to simple allocative problems. I illustrate this definition by highlighting distinctively price theoretic approaches to prominent research practices (diagrams and problems sets) and substantive research topics (e.g. selection markets and media slant). I trace the origins of price theory from the early nineteenth century through its segregation into the Chicago School in the last quarter of the twentieth. I argue that price theory plays a valuable complementary role to two traditions, "reductionism" and "empiricism," with which I contrast it and show how this contribution of price theory has fueled a resurgence in this style of research in fields ranging from market design to international trade. Approximations critical to price theory are less formally developed than tools used in other methodological traditions, suggesting a research agenda to clarify the accuracy and range of validity of these methods.

(b)

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? In a discussion of this well-known ‘Diamond-Water Paradox,’ Adam Smith (1776) observes that [t]he 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.” (p. 31) For him, diamonds and other precious stones derive their value from their relative scarcity and the intensity of labor required to extract them. 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. About a century later, the work of Carl Menger, William Stanley Jevons, and L´eon Walras brought a different resolution of the Diamond-Water Paradox, based on marginal utility rather than labor. Menger (1871) points out that the value of an item is intrinsically linked to its utility ‘at the margin.’ While the first units of water are critical for the survival of an individual, the utility for additional units quickly decreases, which explains the difference in the value of water and diamonds. Commenting on the high price of pearls, Jevons (1881) asks “[d]o men dive for pearls because pearls fetch a high price, or do pearls fetch a high price because men must dive in order to get them?” (p. 102), and he concludes that “[t]he labour which is required to get more of a commodity governs the supply of it; the supply determines whether people do or do not want more of it eagerly; and this eagerness of want or demand governs value” (p. 103). Walras (1874/77) links the idea of price to the value of an object in an exchange economy by noting that the market price of a good tends to increase as long as there is a positive excess demand, while it tends to decrease when there is a positive excess supply. The associated adjustment process is generally referred to as Walrasian tˆatonnement (“groping”). Due to the mathematical precision of his early presentation of the subject, Walras is generally recognized as the father of general equilibrium theory.1 To understand the notion of price it is useful to abstract from the concept of money.2 In a barter where one person trades a quantity x1 of good 1 for the quantity x2 of good 2, the ratio x1/x2 corresponds to his price paid for good 2. If apples correspond to good 1 and bananas to good 2, then the ratio of the number of apples paid to the number of bananas obtained in return corresponds to the (average) price of one banana, measured in apples. The currency in this barter economy is denominated in apples, so that the latter is called the num´eraire good, the price of which is normalized to one. The rest of this survey, which aims at providing a compact summary of the (sometimes technical) concepts in price theory, is organized as follows. In Section 2, we introduce the concepts of “rational preference” and “utility function” which are standard building blocks of models that attempt to explain choice behavior. We then turn to the frictionless interaction of agents in markets. Section 3 introduces the notion of a Walrasian equilibrium, where supply equals demand and market prices are determined (up to a common multiplicative constant) by the self-interested behavior of market participants. This equilibrium has remarkable efficiency properties, which are summarized by the first and the second fundamental welfare theorems. In markets with uncertainty, as long as any desired future payoff profile can be constructed using portfolios of traded securities, the Arrow-Debreu equilibrium directly extends the notion of a Walrasian equilibrium and inherits all of its efficiency properties. Otherwise, when markets are “incomplete,” as long as agents have “rational expectations” in the sense that they correctly anticipate the formation of prices, the Radner equilibrium may guarantee at least constrained economic efficiency. In Section 4 we consider the possibility of disequilibrium and Walrasian tˆatonnement as a price-adjustment process in an otherwise stationary economy. Section 5 deals with the problem of “externalities,” where agents’ actions are payoff-relevant to other agents. The presence of externalities in markets tends to destroy the efficiency properties of the Walrasian equilibrium and even threaten its very existence. While in Sections 3 and 4 all agents (including consumers and firms) are assumed to be “price takers,” we consider strategic interactions between agents in Sections 6 and 7, in the presence of complete and incomplete information, respectively. The discussion proceeds from optimal monopoly pricing (which involves the problems of screening, signaling, and, more generally, mechanism design when information is incomplete) to price competition between several firms, either in a level relationship when there are several oligopolists in a market, or as an entry problem, when one incumbent can deter (or encourage) the entrance of other firms into the market. Section 8 deals with dynamic pricing issues, and in Section 9 we mention some of the persistent behavioral irregularities that are not well captured by classical price theory. Finally, Section 10 concludes and provides a number of directions from which further research contributions may be expected.

The major limitations of Pice Theory are:-

1. It simply provides a theoretical analysis of the working of the individual parts of the economy. But the operation of individual parts does not give a true picture of the working of the economy. Every economic unit is so complex and requires such minute description and analysis that price theory is unable to do justice.

2. It only lays down guidelines based on a given data. Often the data are not reliable. It is based on estimation which may prove to be wrong.

3. Even the assumption of rationality on which decision-making is based to achieve the most efficient use of scarce resources is seldom observed by businessmen and consumers. Still, the assumption of rationality helps in economizing scarce resources with efficiency.

4. Price theory may not give a description of the real world since it is based on limited data and unrealistic assumptions but by concentrating on the most important data we get an insight into the working of the economy.

I argue that there exists a coherent and relevant tradition in economic thought that I label "price theory." I define it as neoclassical microeconomic analysis that reduces rich and often incompletely specified models into "prices" (approximately) sufficient to characterize solutions to simple allocative problems. I illustrate this definition by highlighting distinctively price theoretic approaches to prominent research practices (diagrams and problems sets) and substantive research topics (e.g. selection markets and media slant). I trace the origins of price theory from the early nineteenth century through its segregation into the Chicago School in the last quarter of the twentieth. I argue that price theory plays a valuable complementary role to two traditions, "reductionism" and "empiricism," with which I contrast it and show how this contribution of price theory has fueled a resurgence in this style of research in fields ranging from market design to international trade. Approximations critical to price theory are less formally developed than tools used in other methodological traditions, suggesting a research agenda to clarify the accuracy and range of validity of these methods.