Probably there is no subject to which the businessman gives more attention than that of prices and their determination and behavior. It is through the price mechanism that the various market forces that determine the nature of transactions are brought together. The successful entrepreneur must adjust his activities to changing market relationships so that a margin will exist between the prices of the things he sells (revenue) and the items he buys (costs). In order to make the managerial decisions that will enhance the success of his enterprise, it is essential that the businessman understand the forces that determine prices. Likewise, it is of equal importance for Government officials and judges to understand the nature of prices, since so many laws are concerned with price behavior.
As a starting point, 'we may state the simple proposition that the price of anything is determined by the interaction of the laws of demand and supply. This proposal immediately suggests that there is a system for determining prices and that arbitrary action alone is an inadequate explanation of price-setting and price movements. The simplicity of the demand-and-supply approach should not mislead one into believing that the price mechanism is a very simple one. There are numerous, complicated and interrelated forces with all sorts of ramifications underlying demand and supply. Neither of these components of price is self-determining; there are a multitude of dynamic forces in constant operation. It is essential, then, to go beyond the proposition of demand and supply and seek out the forces that affect these determinants.
Demand customarily is defined aggregatedly as the various amounts of a given good that would be purchased by buyers at various prices. To make demand effective, it is necessary that the potential buyers have both the desire to buy an item and the necessary purchasing power. Desire is a reflection of what the buyer thinks the purchase will do for him--that is, will his satisfaction be recompense for the expenses entailed or losses suffered through the purchase? There are as many factors that determine demand as there are subjective elements influencing individual behavior. The sensitivity of demand is expressed as its elasticity. A demand that is very responsive to price changes is termed relatively elastic (for example, luxuries); one that is not so responsive is called relatively inelastic (necessities). The availability of substitutes is as important in affecting demand elasticity as is the degree of necessity or luxury character possessed by the commodity. Over the passage of time, demand may change as factors influencing buyer decisions are altered. Thus, there may be a change in income status, in the propensity to consume or to save, in family responsibilities, in attitudes about the future, or in ideas about the want-satisfying power of the item as the result of experience or sales promotion.
On the other side of the picture is supply. Supply reflects the various amounts which the sellers are willing to offer at various prices. Behind these quantity-price relationships are costs to the producers. Costs may be of a fixed or of a variable nature. The former do not vary in total as output fluctuates; the latter do change with changes in the quantity of production. To compute the cost of producing a good it is necessary to consider both of these types of costs. Businessmen are also interested in average and marginal costs. Average costs are arrived at by taking the total of all costs and dividing this figure by the number of units being produced. Marginal costs, on the other hand, refer to the increase in cost occasioned by producing an additional unit (one or a batch) of output.
When demand and supply are brought together through market relationships--and it is impossible to have any price transaction without this meeting of demand and supply--price is determined and sales and purchases are made. From sales, the entrepreneur derives his revenue. He is interested in unit or average revenue as well as total and marginal revenue. The latter represents addition to his total revenue through the sale of an additional unit.
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