# Understanding the Theory of Price: Supply, Demand, and Market Equilibrium

![Theory of Price: An economic theory that states that the price for a specific good or service is determined by the relationship between its supply and demand at any given point.](https://www.investopedia.com/thmb/FzqFBSNd2zgtaFVoDKLhdtDsULc=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/theory-of-price.asp-Final-24772f8216aa42a6b02a1ca42f8b84da.jpg)

*— Yurle Villegas / Investopedia*

> **Definition**
>
> The theory of price states that goods and services prices are decided anytime by the interplay of supply and demand.

## What Is the Theory of Price?

The theory of price provides a framework for understanding how prices are determined in a market economy and how these prices influence economic behavior and resource allocation.

This economic theory states that the price of a specific good or service depends on its [supply and demand](https://www.investopedia.com/terms/l/law-of-supply-demand.asp). Prices should rise if demand exceeds supply and fall if supply exceeds demand. Producers aim to charge the highest price feasible, while consumers seek lower prices. Market equilibrium occurs when supply matches consumer demand.

### Key Takeaways

*   The theory of price explains how supply and demand determine prices in a market economy.
*   Equilibrium is reached when the supply of goods matches consumer demand.
*   Prices adjust based on changes in market conditions, reflecting the interaction between supply and demand.
*   Producers aim to charge as much as possible, while consumers seek to pay the least, leading to a balance point.
*   The clearing price is the optimal price where supply matches consumer demand.

## Exploring the Principles of Price Theory

Price theory, also known as the theory of price, is a [microeconomic](https://www.investopedia.com/microeconomics-4689797) principle.

In a [free market](https://www.investopedia.com/terms/f/freemarket.asp), producers aim to charge the highest reasonable price, while consumers seek to pay the least. Market forces will cause the two sides to meet somewhere in the middle, at a price consumers are willing to pay and producers are willing to accept.

Market [equilibrium](https://www.investopedia.com/terms/e/economic-equilibrium.asp) occurs when the available quantity of a good matches consumer demand. The concept of price theory, which says the market forces of supply and demand will determine the logical price point for a particular good or service at any given time, allows for price adjustments as market conditions change.

## How Supply and Demand Influence Price Theory

[Supply](https://www.investopedia.com/terms/s/supply.asp) denotes the number of products or services that the market can provide. This includes both tangible goods, such as automobiles, and intangible ones, 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 and appointments available at any given time.

Factors beyond a producer's control, like raw material availability, can affect supply.

[Demand](https://www.investopedia.com/terms/d/demand.asp) 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 can change if a better product version is available or if a service becomes unnecessary. Demand can also be affected by an item’s perceived [value](https://www.investopedia.com/terms/v/value.asp) in the consumer market.

Equilibrium happens when the supply equals consumer demand. If a price is too high, customers may avoid the goods or services or find other alternatives. This would result in excess supply and possibly cause producers to lower prices.

In contrast, if a price is too low, demand may significantly outpace the available supply, causing prices to rise again. The optimal price, taking into account both supply and demand, is also referred to as the [clearing price](https://www.investopedia.com/terms/c/clearingprice.asp).

## Practical Example: Price Theory in Action

Companies often [differentiate their product lines](https://www.investopedia.com/terms/p/product_differentiation.asp) vertically, rather than horizontally, considering consumers’ differential willingness to pay for quality. As noted by Michaela Draganska of Drexel University and Dipak C. Jain of INSEAD in the journal _Marketing Science_, many firms offer products that vary in characteristics like color or flavor, but that do not vary in quality.

Their study found that using uniform prices for all products in a particular product line tends to be the best pricing policy for producers.

For example, Apple Inc. offers several different MacBook Pro laptop computer models, with varying screen sizes, capabilities, and prices. The customer has a choice of two colors: silver and space black. If Apple charged a higher price for a 14-inch silver MacBook Pro vs. an otherwise identical space black one, demand for the silver model might fall, and the available supply of the silver model would increase. At that point, Apple might be forced to reduce the price of that model.

## What Is the Difference Between Microeconomics and Macroeconomics?

[Microeconomics](https://www.investopedia.com/terms/m/microeconomics.asp) focuses on interactions between individual consumers and the producers of goods and services, while [macroeconomics](https://www.investopedia.com/terms/m/macroeconomics.asp) looks at the economy as a whole.

## What Is Elasticity of Demand?

Elasticity of demand, or [price elasticity of demand](https://www.investopedia.com/terms/p/priceelasticity.asp), measures how sensitive the demand for a particular good or service is to changes in its price. If raising the price of a product will have little effect on the demand for it, it is said to be relatively [inelastic](https://www.investopedia.com/terms/e/inelastic.asp).

## What Is a Supply Curve?

A [supply curve](https://www.investopedia.com/terms/s/supply-curve.asp) illustrates the relationship between prices and supply. As the price rises for a particular good or service, the more of it producers will be motivated to provide.

## What Is a Demand Curve?

The [demand curve](https://www.investopedia.com/terms/d/demand-curve.asp) is a graphic illustration of how prices affect supply and demand. As prices rise, the quantity of a particular good or service that consumers demand will decline. Conversely, as prices fall, demand rises.

When a supply curve and a demand curve for a particular item are overlaid on the same graph, the point at which they intersect is referred to as the [equilibrium](https://www.investopedia.com/terms/e/equilibrium-quantity.asp) point. That’s the price at which the quantity consumers are willing to buy and the quantity producers are willing to deliver are perfectly matched.

## The Bottom Line

The [theory of price](https://www.investopedia.com/terms/m/microeconomic-pricing-model.asp) is a fundamental economic principle that explains price determination through the interaction of supply and demand. Market equilibrium is achieved when supply matches demand, resulting in stable prices. Price adjustments can occur when there is an imbalance between supply and demand, which can lead to price increases or decreases.

Both producers and consumers reach a compromise on price in a free market, balancing maximum profit for producers and minimum cost for consumers. Understanding these dynamics can help consumers and businesses make better pricing and purchasing decisions.

> **Article Sources**
>
> 1.  Draganska, Michaela, and Dipak C. Jain. “[Consumer Preferences and Product-Line Pricing Strategies: An Empirical Analysis](https://www.researchgate.net/publication/226650982_Consumer_Preferences_and_Product-Line_Pricing_Strategies_An_Empirical_Analysis).” _Marketing Science_, vol. 25, no. 2, March 2006, pp. 164–174.
>     
> 2.  Apple. “[MacBook Pro](https://www.apple.com/macbook-pro/?afid=p238%7CsWcn8aIOn-dc_mtid_1870765e38482_pcrid_661049781960_pgrid_111487297858_pntwk_g_pchan__pexid__&cid=aos-us-kwgo-mac--slid---product-).”