What Is The Price Effect?
The price effect in economics states the Impact of price on the Demand for goods and services due to slight fluctuation. The primary purpose of this concept is to determine the relationship between price and quantity purchased. Therefore, it helps to determine the elasticity of demand for a particular product or service.
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Businesses can determine the optimal price point for their product or service by analyzing this effect. Hence, two types of impact influence price: income and substitution. Yet, other factors include changes in interest rates and other monetary policies. It indicates how consumers react when the prices of products change. However, other things remain constant.
Table of contents
- What Is Price Effect?
- Price Effect Explained
- Price Effect Formula
- Examples
- Graph
- Price Effect And Income Effect
- Price Effect vs Output Effect
- Frequently Asked Questions (FAQs)
- Recommended Articles
Key Takeaways
- Price effect in economics refers to the consequence or impact of price on the demand for goods and services. It is a combination of both income and substitution effects.
- The effect of the price depends on the nature of the goods. For example, standard and Giffen (inferior) goods have positive and negative effects. However, neutral goods have zero impact.
- A high impact on price indicates that a slight change in the price of goods or services leads to a significant shift in demand. At the same time, a common effect on price suggests that a price change has little impact on the market.
Price Effect in Economics Explained
The price effect in economics refers to the effect of price on the consumer’s demand. It usually happens due to the fluctuation or change caused by monetary or fiscal policies. As a result, it causes a direct impact on the prices of goods and services. Later on, this effect is seen in the demand for these products. However, the theory assumes the principle of “Ceteris Paribus,” which means all other factors remain constant.
Hence, it is necessary to consider the nature of goods to understand this effect. It includes regular, Giffen (non-luxury goods), and neutral goods. Therefore, in the case of common goods, the impact of price on demand is positive. So, if the cost of these goods falls, the consumer’s income increases, and the product’s demand increases. In contrast, if the price increases, its demand will fall. As a result, it causes an indirect relationship between price and quantity purchased.
Likewise, for Giffen or Inferior Goods, this effect is negative. So, if the price of these goods falls, their demand reduces. These goods include wheat, rice, potatoes, and other essentials. Thus, it leads to a direct relationship between them. However, for neutral goods, there is a zero-price effect. As a result, the quantity demanded remains the same. In zero price effect, the demand remains fixed, even if the prices rise or fall. However, for some related goods, there is a cross-price effect that means a change in the price of one commodity causes a shift in demand for another. For example, petrol and cars are related goods with a cross-price effect.
Price Effect Formula
Let us look at the price effect formula to understand the concept in a better way:
Price Effect = (Proportionate change in the quantity demanded of X) / Price change of commodity X)
Where,
Proportionate change refers to the current demand minus the previous year’s demand.
And price change refers to the difference between the current and previous prices.
Hence, several other factors, such as consumer preferences, income levels, availability of substitutes, and competing products or services, can influence this effect.
Examples
Let us look at the examples of price effect and their relevance in the modern market:
Example #1
Suppose ABC firm has been dealing in the chocolate business for the past 15 years. They import premium quality cacao beans from Ecuador in South America. However, in 2022, when the government removed certain trade restrictions on cacao beans, it reduced the price of chocolates. In addition, this incident occurred right before Christmas. As a result, the demand for chocolates leaped. However, if the Ecuadorian government had imposed restrictions, the price effect would have caused a fall in demand, causing a positive impact.
Example #2
Let’s say the Los Angles Theatre raises the price of a movie ticket from $10 to $12. After the price increases, the theater experiences a 5% decrease in ticket sales.
However, in this example, the price effect is the decrease in ticket sales resulting from the price increase. Hence, the theatre’s decision to raise the price of their movie tickets influenced consumer behavior, leading to a decrease in demand for their product. Furthermore, this effect could be further analyzed to determine the elasticity of demand for movie tickets and to help the theatre make informed decisions about future pricing strategies and revenue projections.
Graph
Let us look at the graph of the price effect theory to understand the concept:
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In the above picture, all three graphs depict the price effect on normal, Giffen, and neutral goods. Simultaneously, PCC is the price consumption curve due to the changing prices. In addition, A1, A2, and A3 refer to the budget line, which states how consumers’ real income shifts.
1. Figure 1.0
The first graph shows how consumer demand for products X & Y reacts to the changing prices. It is to be noted that these goods are standard. At initial budget A1, a person demands OQ and OC units of X & Y. However, as the prices increase, the person’s budget falls short. As a result, the demand decreases for OR and OB. Likewise, they get a chance to spend more when the price drops. Thus, they demand more goods (OD and OP). Therefore, the PCC in the common goods is upward-sloping, leading to a positive price effect.
2. Figure 2.0
In the second graph of Giffen or inferior goods, A1 is the initial budget line, whereas A2 and A3 are budget lines after the price change. In contrast, Product X is a defective product, while Product Y is a substitute for it. At the initial budget line (A1), a consumer demands OC1 and OQ1 products. If the price falls, the person will have extra income, shifting the budget line to A3. At this point, instead of buying more Giffen goods, they will choose a little costly product. Therefore, the demand falls to OB1 and OR1.
Similarly, when the price rises, the budget line gets rigid (A2). As a result, consumers find inferior goods more affordable than costly goods. Therefore, the demand for the product rises from OC1 to OD1. Thus, the price effect for these goods is negative, resulting in downward sloping bending left towards X-Axis. However, this slope can also turn towards the Y-axis.
3. Figure 3.0
The last graph depicts the price effect in the case of neutral goods, where any change in price causes no impact on demand. Since the demand for these goods is inelastic, it stays constant throughout. As a result, the PCC curve is either horizontal or vertical slope parallel to the X and Y-axis.
Price Effect And Income Effect
Price effect and income effect are essential concepts in economics that help explain consumer behavior in response to changes in prices and income. Let us take a look at the comparison:
| Aspect | Price Effect | Income Effect |
|---|---|---|
| Definition | The changes in quantity demanded of a product that occurs as a result of a change in its price | It refers to a change in quantity demanded that occurs as a result of the change in consumer income. |
| Cause | Change in price of the product | Affects changes in consumer income |
| Type of change | Negative for the price increase, positive for a price decrease | Positive for normal goods, negative for inferior goods |
| Relationship with price | Inversely related to the price | Not directly related to the price |
Price Effect vs Output Effect
Although price and output effects are crucial factors for the monopoly market, they have some differences between them. So let us look at them:
| Aspect | Price Effect | Output Effect |
|---|---|---|
| Meaning | It refers to the effect of price on the demand for products. | It refers to the effect on output due to a change in the input variable. |
| Purpose | To determine the impact of price on the income and quantity demanded by the consumer. | To find the effect on output when any input variable like raw materials, labor, or other factors of production fluctuates. |
| When price reduces/falls | For normal goods, it is positive, while for inferior goods, it is negative. Whereas for neutral goods, it is zero. | Output rises, and demand increases as the products are available at a lower rate. |
Frequently Asked Questions (FAQs)
Although price and substitution effects are interrelated, they have differences between them. While the former determines its impact on demand, the latter is a part of it. The substitution effect states how consumers will replace inferior goods with costly ones if the prices fall and vice versa.
The factors influencing the effect on price are as follows:
– The monetary and fiscal policies.
– Changes in interest rates.
– Availability of substitutes
– Changes in the factors of production.
– Others.
For example, if the labor gets expensive, the firm might raise the price of products.
The price effect does control the quantity effect as the firm’s marginal curve lies below the demand curve. However, this dominance depends on the elasticity of demand for the product.
Recommended Articles
This article has been a guide to what is Price Effect. We explain it with its formula, comparison with output and income effects, graph, & examples. You may also find some useful articles here –
- Decoy Effect
- Price Floor
- Price Sensitivity
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