II.

Determination of Prices by Supply and Demand

Both supply and demand factors decide the prices of commodities: prices will fall if there is too much supply and rise if there is too much demand, until equilibrium is reached. On the supply side, prices are fixed by costs of production and distribution, as determined by scarcity of materials, technology, organizational limits like the law of diminishing returns, labour costs, and so on. The producer will decide his pricing strategy to maximize his profits, though other wishes of the sort covered by theory of the firm may also operate. However, the nature of the market also comes into play: in a monopoly or oligopoly, the price can be raised still further because competition is not operating freely. A cartel can fix prices between them; long-term company strategy may dictate the choice of a price below market value or even below cost; game theory may be influencing the decisions of firms. In practice, few markets are perfectly competitive, and the bias usually favours the supplier.

Demand is the sum of the separate purchasing decisions by the buyers in a market as they each attempt to maximize available utility. Of course, this assumes that buyers are making rational choices: just the ones which advertising and marketing exist to circumvent. A company's efforts to dictate demand may even feed back into the price, through extra costs of a promotional budget. People will decide whether to buy a commodity according to its price, but in practice demand, once in play, will decide how many units of a commodity are sold rather than its price, for most companies will produce a new commodity rather than let the fixed price of the old one drift towards an equilibrium level. Nor are low prices automatically best: quality goods may not sell at rock-bottom prices because consumers suspect faults or because the commodity loses the exclusivity which is actually its utility. The kind of purchase via haggling implied by many free market economic models can in fact operate only rarely in modern integrated economies, so that the relationship of prices to demand is often considerably less direct than economic theory implies.