Analysis of the determination of prices of goods and services in the market is an indispensable part of the subject matter of economic theory. When an economy is guided by market mechanism, prices are determined by interaction between demand and supply forces, that is, they are the result of an interaction between decisions taken by buyers and sellers.
This is so at all levels of prices, right from the price of an individual good to where all prices are considered simultaneously. To analyze the determination of all prices simultaneously is obviously a very complex task and can be handled only in stages. Therefore, we begin with a small part of the problem and extend the findings, in stages, to the economy as a whole. It goes without saying that, at each stage, both demand and supply sides have to be studied and analyzed.
In this task, we begin with the question of determination of price of a single good or service (the terms good or service will be used interchangeably by us). Decisions relating to its supply are taken by the body of its suppliers comprising all the ‘firms’ of an ‘industry’. As is obvious, their decisions vary with the market structure and other circumstances. Similarly, decisions relating to its demand are taken by the body of its buyers. Their decisions are also influenced by the market structure and several other relevant considerations.
While analyzing the demand side, we assume that the good service in question is consumption good. We start with the factors, which determine the decision-making of a typical consumer, and extend the conclusions to the market and the economy as a whole. Therefore, as a first step, various relevant questions are asked and their answers used to determine the demand behavior of a typical individual consumer. These findings are then extended to arrive at the ‘market demand’ for the good, that is, the demand by all the potential consumers taken together. Finally, the determination of price of an individual good is analyzed by incorporating its supply side that is the decision-making behavior of its suppliers.
Demand for a good by a consumer is not the same thing as his desire to buy it. A desire becomes a demand only when it is ‘effective’ which means that, given the price of the good, the consumer should be both willing and able to pay for the quantity, which he wants to buy.