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9.2. Economic Theories Of Pricing And Value
Classical economists assumed that prices would automatically be set by the laws as prices rise, more suppliers find it profitable to enter the market, but the demand for the product falls because fewer customers think the product is worth the money. Conversely, as prices fall there is more demand, but fewer suppliers feel it is worthwhile supplying the product so less is produced. Eventually a state of equilibrium is reached where the quantity produced is equal to the quantity consumed, and at that point the price will be fixed. Unfortunately this neat model has a number of drawbacks.
- The model assumes that customers know where they can buy the cheapest products (i.e. it assumes perfect knowledge of the market).
- Secondly, it assumes that all the suppliers are producing identical products, which is rarely the case.
- Thirdly, it assumes that price is the only issue that affects customer behaviour, which is clearly not true.
- Fourthly, it assumes that customers always behave completely rationally, which again is substantially not the case.
- Fifthly, there is an assumption that people will always buy more of a product if it is cheaper. This is not true of such products as wedding rings or artificial limbs.
- Finally, the model assumes that the suppliers are in perfect competition – that none of them has the power to ‘rig’ the market and set the price.
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The model does, at least, take account of customers, and it was the pioneer economist Adam Smith who first said that ‘the customer is king’. Unfortunately the shortcomings of the model mean that it has little practical use, no matter how helpful it is in understanding a principle. Economists have therefore added considerably to the theory. Elasticity of demand - This concept states that different product categories will show different degrees of sensitivity to price change. A product where the quantity sold is affected only slightly by price fluctuations, i.e. the demand is inelastic. An example of this is salt. A product where even a small difference in price leads to a very substantial shift in the quantity demanded, i.e. the demand is elastic. An example of this is borrowed money, e.g. mortgages, where even a small rise in interest rates appears to affect the propensity to borrow. The price elasticity of demand concept implies that there is no basis for defining products as necessities or luxuries. If a necessity is defined as something without which life cannot be sustained, then its demand curve would be entirely inelastic: whatever the price was, people would have to pay it. In practice, no such product exists.
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