Main economic factors that determine price of goods

The main economic factors that determine the price of a good or service are Demand and Supply.

Individual demand or individual supply doesn’t determine the price of goods or services, rather the demand created by all the buyers (market demand) and the supply from all the firms (market supply) determines the price. The price at which quantity demanded is exactly equal to the quantity supplied is called equilibrium market price. (Pass and Lowes, 2005)

DEMAND: In economic analysis, Demand is the willingness and ability to pay for a product not merely wants or need of that product. (Pass and Lowes, 2005)

Law of Demand:

When the price of good rises, the quantity demanded will fall. This relationship is known as Law of demand. (Sloman and Sutcliffe, 2001) Hence there is an inverse relationship between price and quantity demanded.

With the inverse relation, most commonly used form of demand curve is linear demand curve represented by Q = a – bP, where b is the slope of the curve, indicating constant slope and “-” sign indicating downward slope.

Determinants of Demand:

Demand for a good X = f (Price of good X, Price of other goods, Income of the consumer, Tastes and Preferences, etc) (Lipsey and Chrystal, 2007)

Demand function is a multivariate function, implying it is determined by many variables. The result of change in the price of X is shown through movement along the curve and the effect of changes in other determinants (like price of related good, consumer’s income, tastes and preferences) is shown through the shifts in demand curve. Therefore, changes in demand can be segregated in two forms:

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Change due to the price of good demanded, i.e. X, and is shown through movement along the curve. The factors that change the slope of a demand curve are availability of substitutes, length of the adjustment period and the proportion of budget that a good represents. With greater number of substitutes, longer adjustment period and larger proportion of the budget that the good represents the demand curve becomes flatter.

Source: Lowes, 2010

Table 1: When price decreases from P0 to p1 there is a rise in the quantity demanded from Q0 to Q1. There is negative relationship between the Demand and the price of the product.

Change due to shift factors like consumer’s income, price of related good, tastes, etc. is shown through the shift of the demand curve.

Figure Figure

Table 2: If there is an increase in consumer’s income, there will be rightward shift in the demand curve. This would imply that at each old price, increased quantities will be demanded on account of increased consumer’s income. Similarly In figure 2 if there is a decrease in the consumer’s income there will be a shift toward left in the demand curve.

SUPPLY: The supply of a good indicates how much a firm is willing to sell per period of time not how much they actually sell. (Lipsey and Chrystal, 2007)

Law of Supply:

When the price of the good rises, the quantity supplied of it in the market increases, and when the price of the good falls, the quantity supplied decreases, ceteris paribus. Quantity supplied is positively related to the price.

The law of supply and upward sloping supply curve is based upon two important assumptions:

(1). Producers or sellers aim to maximise profits from production and sale of the good

(2). Secondly, as output of a good is expanded, the additional cost of producing an extra unit goes up due to diminishing returns to variable factor. So when the costs increase in response to increased output, producers (in order to maximise profits) will be willing to supply the good only at a higher price.

Therefore, it is the rising marginal cost of additional units of output along with the objective of maximisation of profits on part of the producers that causes supply curve to be upward sloping.

Determinants of Supply:

Supply of good X = f (Price of good X, Prices of Inputs, State of Technology, etc).

While talking of the supply of good X, we trace the relationship between the price of good X and the quantity supplied, keeping other factors same. The changes in Supply can be segregated in two ways:

(1). Movement along the supply curve (that is higher price, higher quantity supplied; lower price, lower quantity supplied)

(2). Change due to other factors/shift factors like price of the inputs/resources, state of technology, price of related goods, Expectations about the future, etc. If sellers expect that resource prices will soon rise, supply will decrease. If sellers expect that resource prices will soon fall, supply will increase.

http://www.investment-education-diary.com/image_files/Supply-Curve.JPG

Table 3: The supply curve relates quantity supplied to the prices. The positive slope indicates that quantity supplied increases as prices increases. There is a positive relationship between the Quantity supplied and the price of the product.

http://www.investment-education-diary.com/image_files/Supply-Curve-Shift.JPG

Table 4: The leftwards shift from supply curve S1 to S2 indicates decrease in Supply, so if the Demand remains the same, prices will go up. As shown in above graph at Quantity Q1 Price P1 is now P3, and price P2 is now P4.

Market Equilibrium:

Market equilibrium occurs at the price where consumer willingness to demand is exactly equal to firm willingness to supply. (Begg and Ward, 2009) The interaction of market demand and supply determines the price of the goods or services.

http://theburks.us/images/supply_demand.jpg

Table 5: The equilibrium price corresponds to the intersection of the demand and supply curve. The quantity demanded equals to the quantity supplied. At price above equilibrium there is an excess supply and downward pressure on price. At price below equilibrium there is excess demand and upward pressure on price.

Changes in Market Equilibrium:

Market equilibrium can change on account of changing demand, changing supply. Therefore, we have 2 cases. One when demand changes and supply is unchanged and second when supply changes and demand is unchanged.

(1). Change in Demand – Leftward (decrease) and Rightward (increase)

Rightward (increase): Impact of increase in demand on market equilibrium

Leftward (decrease): Impact of decrease in demand on market equilibrium.

(2). Change in Supply – Leftward (decrease) and Rightward (increase)

Rightward (increase): Impact of increase in supply on market equilibrium

Leftward (decrease): Impact of decrease in supply on market equilibrium

Increase in demand is the most important factor for causing inflation, which is rise in prices and is referred to as demand-pull inflation. Although inflation is the “general rise in price level”, but the roots are at the micro-level as in the case of individual goods.

The supporting readings cover the rising price of cotton and the extent to which this raw material cost will be passed onto retailers by the UK fashion retailer NEXT. Using this example or one from your own professional experience, Examine within your answer the circumstances that will enable a company to pass on cost increases to customers and protect profit margins.

Plausible reasons for rising price of cotton:

After trading at low prices for last few years, cotton prices have risen in 2009/10 to their highest levels in almost 15 years. In April 2010, the Cotlook ‘A’ Index (widely considered to be a proxy for the world price of cotton) averaged 88.1¢/lb, for a 55.1% year-over-year increase.

In response to low cotton prices in past few years, farmers reduced their cotton acreage, the farmers more likely shifted to crops like corn and soybeans which might have looked more profitable. As a result the cotton production in 2009/10 crop year has fallen 15.3% than in 2004/05. (Cotton Incorporated 2010)

The supply condition was further worsened by the losses in Pakistan and the export ban on cotton in India (The Financial Times Ltd 2010) Thus the gap between the world cotton production and consumption became wider.

The tight supply conditions imply decreased supply of cotton, leading to leftward shift of the supply curve of cotton. Given the unchanged demand curve for cotton, at the old equilibrium point, there will be shortage, leading to upward pressure on the price of cotton. Therefore the new equilibrium will be at much higher price and lower quantity.

Prices pressure in the supply chains:

Higher fiber prices and competition for manufacturing capacity have contributed to price pressure in supply chains. The retailers like NEXT are facing the question of how much of their increased costs they can pass on to customers. The unprecedented price levels and volatility in fibre prices corresponding to the tight fibre supply situation has made pricing difficult throughout the cotton supply chain. Cotton (Incorporated 2010)

Therefore for protecting the profit margins, it is important for the firms to control costs. If rate of increase of sales is greater than that of the costs of production, then the Company will end up with more profit margins.

Elasticity of Demand:

The price fixation by the firms and the extent to which it is possible for the firms to transfer the burden of increased costs on to the customers depends upon the elasticity of demand for that product.

Following the law of demand that quantity demanded is inversely related to the price of the good, holding other things constant, we have responsiveness or sensitivity of quantity demanded to change in the price of the good. How responsive is quantity demanded to the change in price is referred to as the elasticity of demand and this sensitivity depends on factors like availability of substitutes, time period, nature of the good under consideration (necessity, luxury), and the proportion of income spent on the good by the consumer. Greater the number of substitutes, longer the time period of adjustment, higher the proportion of income spent on the good imply higher elasticity of demand and vice-versa.

With higher elasticity of demand, even a small change in price (say increase) would lead to a substantial change (fall) in quantity demanded. So, with an elastic demand curve, any attempt on part of the firms/managers to raise the price of their good will lead to substantial fall in their revenues (as the consumers will shift to other substitutes), adversely affecting their profits. On the other hand, with an inelastic demand curve, increase in prices by the firms will increase their profits.

Table 6: The left Figure shows change the in price leads to a small change in the quantity demanded (Inelastic Demand) whereas in the right hand side graph a change in the price leads to large change in quantity demanded (elastic demand).

Elasticity of demand= (% change in quantity demanded / % change in price)

Source: Begg and Ward, 2010

Besides identifying the elasticity of demand of a good (demand side factors), firms also need to consider supply side factors that is production and costs. For maximisation of profits, it is important to efficiently use the factors of production and minimize costs. Firm’s total costs include both fixed costs (that doesn’t change with output) and variable costs (that increase with higher levels of production and decrease with lower levels of production). Furthermore, it is important to recall that the demand for the factors of production like that of raw materials is a derived demand for the production of the final good.

As far as demand for cotton (that is derived from the production of cloth by the clothing manufacturers) is concerned, it is not expected to increase as the demand curve of cloth that uses cotton as an input is relatively elastic ( As we have the substitute available) and therefore any attempt of the retailers such as NEXT to raise the price of cloth (with increased price of cotton we have higher costs of production of cloth as the prices of other inputs like labour and energy were already high. Now cloth manufacturers have to absorb the costs as the retailers cannot pass on the increased cost to the customers given the relatively elastic demand curve) will only lead to decrease in their customer base, leading to fall in their sales and therefore lower profit margins.

Conclusion:

The Company can pass on cost increases to customers depending on the elasticity of demand. To protect its profit margins, the company needs to control its costs and see that the rate of increase of costs is lower than that of the sales. However If NEXT passes on the cost increase to customer and if the customer do not accept higher prices, there will be further pressure on margins throughout the supply chain, which ultimately could reduce order volume and therefore reduce supply-related influence on prices.

References

Begg, D. and Ward, D. (2009). Economics for Business, 3rd edition. McGraw-Hill Education.

Sloman, J. and Sutcliffe, M. (2008). Economics and the Business, 2nd edition. Prentice Hall.

Lipsey, R. and Chrystal, A. (2007). Economics, 11th Edition. Oxford University Press.

Pass, C. and Lowes, B. (2005). The Dictionary of Economics, 4th edition. Harper Collins.

Cotton Incorporated (2010).

http://www.cottoninc.com/SupplyChainInsights/CottonPricingDiscussion/CottonPricingDiscussion.pdf (accessed on 22 Nov 2010).

The Financial Times Ltd (2010). Cotton surges on Asian crop fears. http://www.ft.com/cms/s/0/b0b1a854-c504-11df-b785-00144feab49a.html#axzz15wBVTmA6

(accessed on 21 Nov 2010).

The Financial Times Ltd (2010). Next warns of inflation in clothing prices. http://www.ft.com/cms/s/0/e2299c1a-c091-11df-94f9-00144feab49a.html#axzz15wBkmzRP

(accessed on 21 Nov 2010).