The problem of price formation and the subsequent problem of quantity supplied and quantity demanded of any economic good boils down to supply and demand.
The student of economics should in the first place pay attention to the nature of supply and demand mechanisms.
In the price formation of consumer goods, the actions of consumers is based on the "law" of diminishing utility (as opposed to the "law" of diminishing returns, which governs the behaviour of the firm).
You may notice that the word "law" is used in inverted commas. This is to indicate that we are not talking about laws of the normal kind (physical laws found in nature or legal) but of predictable actions that result only if they manifest themselves under very specific and defined external conditions that are assumed to be equal or constant - ceteris paribus.
One also has to assume certain economic behaviours, otherwise one would not be able to analyse the meaning of these behaviours. For example one assumes the economic motive - that individuals through their actions strive to put themselves in a better position - attain a maximum value to themselves with the minimum exertion or cost to themselves.
Because of the complexity of the real world certain limitations need to be placed on the processes being studied. A first limitation is that there is no time lag in the process of price formation and when there is a change in a condition that translates into change in result immediately. Price information is immediately available to all market participants. So we are talking about a short term and comparative static analysis of price formation.
A second limitation is that in the study of price formation we only work with a situation where perfect competition prevails:
This means that in that market:
* the product is perfectly homogenous (so it does not matter to the buyer who the seller is).
* the number of buyers are so great that no individual seller or group of sellers can exert an influence over the price of the market (one may say that if any agreements exist between sellers it does not matter since there are so many suppliers - the effect is that sellers cannot affect the price level - if they increase their price the purchasers will go elsewhere and there is no incentive to reduce price because they can sell any quantity at a the higher market price).
* There are no barriers to entry (or for that matter any costs for leaving) the market.
At first then price formation under these restrctive limiting assumptions is investigated before they (these assumptions)are dropped in further analyses where more complicated problems in the process of price formation in less perfect competitive markets are explored.
Go to the sub-pages below for a further discussion of the topic.
Charl Heydenrych
February 2011