Price Analysis

Price analysis is an overly complex task for apprentice scholars especially given its coverage in economics publications. This essay aims to help undergraduate students and other readers develop skills applicable to price analysis. Supply and demand form a foundation for that analysis. On the supply side of the analysis, this foundation and those skills are valuable for understanding the status of a firm in terms of whether it is operating near the shut-down point, the break-even point, or somewhere in between. Value also accrues by helping students and readers determine whether a firm is earning a normal profit or an economic profit. The degree of competition is a key feature in these analyses, which falls under the notion of a market structure. There is a variety of ways in which to conduct price analysis whether one examines supply or demand.

The information presented in this essay provides a frame of reference with which to simplify price analysis and to distinguish macroeconomic price levels from microeconomic market prices. Though this essay provides a foundation to examine resource markets, its main purpose to help undergraduate students and other readers develop skills in analyzing prices found in the goods and services market. Specifically, this essay will improve the reader's ability to answer the following questions: Why do prices change or differ? What are the key determinants driving price variations? Which prices are of greatest interest and to whom? How do producer costs interact with the market prices consumers pay and producers receive? Perhaps the most important question is: What do market prices tell us in precise terms about a firm's operating status, its profit level, and its competition?

In order to answer this last question, a need exists to define the term price. Pearce (1992) informs us in a concise manner what the terms price and price level mean. An input's or an output's price is the amount of money that is required to obtain an item whether it is an input or an output. With its focus on consumer and firm behavior, microeconomics is an area of inquiry that focuses, in part, on production decisions and price theory. At a much broader perspective, macroeconomic inquiry concerns itself, in part, with the general level of prices or a price index, which indicates the extent to which the prices for items within a larger bundle of goods change over time. The index is an average of item prices weighted according to the proportion of total expenditures on each item of the bundle. Price analysis in this essay will touch upon that broad perspective, but it conveys many more crucial details about the narrower perspective, especially with regard to production decisions and price theory.

Prices generally reflect an agreement between sellers and buyers who exchange goods and services as they interact in the marketplace. In addition, most sellers take the price dictated by market forces and very few sellers are able to set the market price. As many undergraduate students experience graph phobia, readers of this essay are encouraged to postpone cross references between the text printed herein and the graphs found in textbooks by Guell (2007), McConnell & Brue (2008), or other economists. In the pages at hand, without the aid from and/or the distraction that graphs provide, the reader will gain a preliminary understanding about the foundations of demand and supply before moving onward to examine how inputs and their costs, production rules and outputs, producer's and consumer's willingness and ability, and market forces and structures converge to determine an item's price.

Applications

Foundations of Price Analysis: Demand & Supply

When viewing a two-dimensional graph showing the demand and supply curves in the market for any given item, viewers would notice that its price appears on the vertical axis and its quantity is appears on the horizontal axis. Equilibrium price and quantity occur where quantity demanded equals quantity supplied or where the downward-sloping demand curve intersects the upward sloping supply curve. At this juncture, take note that two forms of movement may occur on the graph: Movement along a curve and a shift in the curve. To keep these movements straight, price analysts should simply note that a change in price initiates movement along the curve whereas a change in a determinant initiates a shift in the curve. An equilibrium point is static at one instance, but it is also dynamic in nature by virtue of a curve shift that results in a different intersection of the demand and supply curve. New intersections and new equilibrium prices and quantities often result from any inward or outward curve shift.

Determinants of Supply & Demand

The demand curve will shift in accordance with a change in a determinant and so will the supply curve. Keep in mind that five determinants exist each for the demand curve and for the supply curve and each can prompt a shift in one curve or both curves. Because it is quite easy to feel overwhelmed and lose track of a critical sequence when more than one curve shift occurs, the author of this essay encourages students to contemplate only one change in one determinant of supply or demand at a time. In other words, each change will likely produce a shift in the curve under consideration.

Before listing the sets of determinants, price analysis is easier by committing to memory various aspects of curve shifts. A rightward, outward, or upward shift in the demand curve is an increase in demand whereas an opposite shift is a decrease in demand. By extension, an increase (decrease) in demand means consumers will purchase a larger (smaller) quantity of an item at any given price. A rightward, downward, or outward shift in the supply curve is as an increase in supply whereas an opposite shift is a decrease in supply. Likewise, an increase (decrease) in supply means producers will supply a larger (smaller) quantity of an item at any given price. In contrast to curve shifts, any movement along a demand curve or a supply curve is respectively a change in quantity demanded or quantity supplied to which there is a corresponding change in price.

The list of five determinants for demand and those for supply is as follows:

Correspondence between prices and quantities is revealed through demand and supply schedules. Construction of these schedules occurs at two levels of aggregation. Compilations of a market-level demand schedule and supply schedule originate with individual-level schedules. All individuals that buy or sell an item constitute the market for that item. Individual demand schedules represent the quantities each consumer are willing and able to purchase at each price. The summation of quantities from those individual demand schedules across each price becomes the market demand schedule. In comparison, market supply schedules represent the sum of quantities that individual producers are willing and able to sell at each price as long as the market price makes it feasible for them to do so, which is one of the subjects discussed in the next section.

Firm Operating Status, Profit Level, & Competitiveness

The price at which producers can sell their goods and services is only one constraint. The relationship between market prices and producer costs, which will resume in the pages that remain, often influences whether item production will occur. Firms incur a variety of costs in their production of goods and services.

Costs to a Firm

Total costs are the sum of fixed and variable costs. Fixed costs are those that exist even without any production. Furthermore, they are constant as they do not vary with the scale of production. Some examples of fixed costs include monthly installments paid for machinery, buildings, and land. Variable costs are those that vary with production. Some examples of variable costs include wages, materials, and supplies. Keep in mind that production worker payroll is usually the firm's largest variable cost.

The allocation of costs across larger scales of production results in a variety of cost curve shapes. Graphs depicting these functions show cost on the vertical axis and quantity on the horizontal axis. Average total cost and average variable cost form important U-shaped curves. Their calculation involves dividing them by the production quantity. The lowest points on those curves are significant. At those points is where the marginal cost curve, which is J-shaped, intersects them. Marginal cost is the change in total costs that arises from producing one additional unit.

Firm Revenue

Firms produce and sell items and they receive a price for each one sold. Total revenue is the mathematical product of price times the quantity sold at each price. Marginal revenue is the change in total revenue that arises from selling one additional unit. Price is equal to marginal revenue in competitive market structures and it is greater than marginal revenue in monopolistic market structures. Though graphs can become quite confusing with each addition of a line or curve, keep in mind that the marginal revenue line is horizontal in perfectly competitive market structures and it is downward sloping in monopolistic structures; a discussion of market structures will resume later.

Rules of Production

A key relationship exists where marginal revenue equals marginal cost and where these two curves intersect. The intersection determines the profit-maximizing amount of output. Most, if not all, firms attempt to set production to that amount as they exhibit profit-maximizing behaviors. Now, let's bring prices back into the analysis for a short discussion of the rules of production. These rules must be met for a firm to continue its operation as a viable entity.

To comply with the first of two rules, firms must produce at the profit maximizing output; again, where marginal revenue equals marginal cost. The second rule is firms must receive a price that is equal to or greater than average variable cost. Why? Their sales must cover, at the least, average variable costs and contribute something toward average fixed costs. In other words, they must cover their variable inputs, labor costs for instance, and make payments on their plants and machinery. Moreover, they must operate at or above the shut-down point, which is where the marginal cost curve intersects the average variable cost curve and at the latter's lowest point.

Another key reference point is the break-even point. It occurs where the marginal cost curve intersects the average total cost curve and at the latter's lowest point. The break-even point also marks the location at which those costs are equal and the firm earns a normal profit. The term is misleading as it seems to indicate an absence of profit. However, profits become part of an operating cost if the owner is to be consistent with the notion of opportunity costs, which is the value the decision maker assigns to the best foregone alternative. In essence, the firm owner expects to earn a specific minimum level of profit in order to remain in the current business. Otherwise, the owner may sell the business using the proceeds to open another business or placing them in a savings account and then go to work as an someone else's employee. Therefore, in order to remain in business, a firm owner or an entrepreneur will pursue the rate of profit considered normal for the market in which he or she conducts business operations and really needs to sell at a market price that covers average total costs.

Market Price Analysis

Any analysis of market prices needs to begin with a focus on whether prices occur at the break-even point, at the shut-down point, or somewhere in between. Depending on the market structures in which they operate, some firms can influence the market price and others merely accept the market price for their outputs. Market structure reflects the firm's ability to make the price or to take the price. In context of microeconomics, structures at the extreme ends of a continuum refer to the presence or the absence of competition in a market for a specific output or item. The book ends of that continuum are perfect competition and monopoly or imperfect competition.

In addition to whether firms are price makers or price takers, market structure descriptors often include the number of sellers and buyers and the ease at which firms can enter or exit a market, and the level of profit. One example of product produced in a perfectly competitive market structure is agriculture. In this instance, there are numerous buyers and sellers of an agricultural product such as corn. Consequently, corn farmers take the price dictated by the market and almost anyone can obtain enough resources to grow corn. An example of a product produced in a monopolistic market structure is a computer operating system. In this instance, there are numerous buyers of the system but only one seller. Consequently, system developers make the price, as they are the only producer, and virtually no one can obtain the resources needed to develop the operating systems software. Furthermore, monopolists produce lower quantities than perfect competitors and they charge higher prices as a result. Moreover, those prices are much higher than the break-even point, which provide monopolists with profit greater than the normal level. An economic profit is earned when prices are higher than average total cost, which usually invites entry into the market. However, entry into the market for software as a producer is virtually impossible mostly due to legal constraints such as licenses and patents.

Variants in Price Analysis

Prices can vary across space and time. Residents in some locations experience a higher cost of living than residents in other locations for a host of factors that may include climate, lifestyle, and popularity. It is likely that the prices for most goods and services are higher in those locations than they are elsewhere. Item prices may also vary across seasons or annual cycles. Fluctuations in prices over time are of at least two forms.

Cobweb Model Analysis

One form is the result of sequential yet interrelated shifts in demand and supply. Without reviewing the five determinants of demand and of supply found elsewhere in this essay, changes in those determinants often prompt changes in demand and/or supply. A specific pattern may be observed by following and tracing out a set of perpetual changes in demand and in supply. Cobweb model analysis, by virtue of its name, as introduced by Waugh in 1964, conveys the pattern in equilibrium points established by a series of shifts in the demand curve and the supply curve. Readers can sketch a cobweb on their own simply by taking an initial price and quantity equilibrium and creating new equilibrium points from a sequence such as this: An increase in demand; an increase in supply; a decrease in demand half the distance toward the first demand curve; a decrease in supply half the distance likewise; and so on. The sketch will provide readers with some idea of the amount of time for the market to approximate a point close to the original equilibrium point.

Price Indexes

Another form of temporal price changes is detectable through a macroeconomic price index. One widely used index is the Consumer Price Index (CPI). It portrays changes in the general price level over time in the overall economy. Comparing a past CPI to the current CPI will allow analysts to estimate the rate of inflation or the percentage change in the CPI. Its mention here is to inform price analysts of its existence and to facilitate their understanding of prices in a market, which is a microeconomic mode of analysis, in contrast to price level for the whole economy, which is a macroeconomic mode.

Conclusion

In conclusion, prices are a key variable whether one is examining the macroeconomic context or analyzing the microeconomic context. In general, the behaviors of firms and consumers reflect their analysis of prices. Both consumers and producers have schedules that serve as records of their willingness and ability to exchange quantities of items at various prices. Producer schedules may be constrained further by cost functions and market structures. In summary, this essay is an attempt to untangle many strands of price analysis in order to facilitate learning at the undergraduate level.

Terms & Concepts

Consumer Price Index: Used as a measure of inflation or change in overall prices for a national economy; calculated from prices on a set of items and then weighted according to consumer expenditures.

Demand: The amount of a good or service an individual consumer or a group of consumers wants at a given price.

Demand Schedule: The actual quantities that consumers are willing and able to purchase at various prices.

Economic Profit: The amount of profit that exists at the profit-maximizing output when prices are above average total costs, exceeding the rate of profit considered normal for a market; attracts potential new entrants into the market.

Equilibrium: The price and quantity associated with the intersection of the demand and supply curve reflecting alignments among consumers and producers on an item's price and quantity.

Equilibrium Price: The price at which demand and supply curves intersect reflecting an agreement among consumers and producers.

Equilibrium Quantity: The quantity at which demand and supply curves intersect reflecting an agreement among consumers and producers.

Fixed Costs: Costs for any level of production or output that remain constant.

Inflation: A general rise in the overall level of prices in an economy; see Consumer Price Index.

Marginal Revenue: the contribution to total revenue from the sale of one additional item.

Market: A virtual space where consumers and producers interact while exchanging a specific item in accordance with their demand and supply schedules.

Monopoly: The firm that is the sole supplier of a good or service within a market, which can determine output level and price and prevent entry of new suppliers.

Normal Profit: The amount of profit considered normal for retaining an entrepreneur in the existing line of business; occurs where price equals average total costs at the profit-maximizing output.

Output: The quantity of items or services produced by a firm or group of firms in a market.

Perfect Competition: the condition of a market in which several buyers and sellers exist, but none of them can influence price though entry and exit are easy to accomplish.

Price: the amount of money that is required to obtain an item.

Price Index: A measure of the overall level of prices in the whole economy.

Producers: Firms that supply or provide goods or services desired by consumers.

Quantity Demanded: The amount of goods or services that consumers desire at given prices.

Quantity Supplied: The amount of goods or services that suppliers are willing and able to produce at given prices.

Revenue: The proceeds from the sale of an item; the mathematical product of quantity of item sold times the price of item.

Supply: The amount of a good or service an individual producer or a group of producers will provide at a given price.

Supply Schedule: The actual quantities that producers are willing and able to purchase at various prices.

Variable Costs: Costs for production or output that vary according to activity level.

Bibliography

Aguirre, M., & Rodríguez, J. (2013). Relación de causalidad entre el índice de precios del productor y el índice de precios del consumidor incorporando cambios estructurales: el caso de los países miembros del tlcan. (Spanish). Global Conference on Business & Finance Proceedings, 8(1), 848-854. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=87078482&site=ehost-live

Arnold, Roger A. (2005). Economics (7th ed.) Mason, OH: Thomson South-Western.

Guell, R. C. (2007). Issues in economics today (3rd ed.). Boston, MA: McGraw-Hill Irwin.

McConnell, C. R. & Brue, S. L. (2008). Economics (17th ed.). Boston, MA: McGraw-Hill Irwin.

Obadia, C. (2013). Competitive Export Pricing: The Influence of the Information Context. Journal Of International Marketing, 21(2), 62-78. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=87742601&site=ehost-live

Peltier, J.W., Skidmore, M., & Milne, G.R. (2013). Assessing the impact of gasoline sales-below-cost laws on retail price and market structure: Implications for consumer welfare. Journal of Public Policy & Marketing, 32(2), 239-254. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=91886742&site=ehost-live

Suggested Reading

Chen, K., Chen, K., & Li, R. (2005). Suppliers capability and price analysis chart. International Journal of Production Economics, 98(3), 315-327. Retrieved September 18, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=18756488&site=ehost-live

Pearce, D. W. (Ed.). (1992). The MIT dictionary of modern economics. Cambridge, MA: MIT Press.

Simmons-Mosley, T.X., Lubwama, C., & Fung-Shine, P. (2013). In retrospect: An early 2000 affordability analysis of house prices in the San Francisco bay area. Journal of International Finance & Economics, 13(4), 49-56. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=91830968&site=ehost-live

Vallarta supermarkets pursues price optimization. (2007). Chain Store Age, 83(2), 38. Retrieved September 18, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=23965869&site=ehost-live

Waugh, F. (1964). Cobweb models. Journal of Farm Economics, 46(4), 732-750

Zaleski, P., & Esposto, A. (2007). The response to market power: Non-profit hospitals versus for-profit hospitals. Atlantic Economic Journal, 35(3), 315-325. Retrieved September 18, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=26218268&site=ehost-live