The concept of price makes sense in the context of a good, service, or commodity that can be bought and sold. To define the price, we need to specify two kinds of units:
- A unit for the good, service, or commodity being sold.
- A unit for the form of money used to pay for the good, service, or commodity.
The price specifies the amount of money (in the chosen units of money) at which one unit of the good, service, or commodity is bought or sold.
Instead of describing prices in terms of money, one can also use relative prices describing the price of one good in terms of another.
A unit price makes sense when the cost-quantity relationship is linear
Consider a commodity measured in specific units, and consider a graph of the total cost as a function of the amount of the commodity bought. If this graph is linear, then the slope of this graph represents the price. However, there may be circumstances where the graph is not linear. If it is concave down, that means that the average price (the cost/quantity ratio) goes down as the quantity bought increases (this phenomenon may be due to efficiencies of scale in larger transactions or due to volume-based price discrimination). If it is concave up, this means that the average price (the cost/quantity ratio) goes up as the quantity bought increases (this may happen due to the local shortfall created after the first few units are bought or sold).
Continuous versus discrete quantities bought and sold
For certain kinds of quantities, the amount that can be bought and solid varies continuously. Examples include physical commodities (oil, gold, etc.) and financially liquid commodities (money and assets). For other quantities, the amount that can be bought or sold can only take discrete values. For instance, refrigerators can only be sold in integer amounts. (However, sufficiently fine-grained discrete things look like continuous things -- Fill this in later).
How are prices determined?
In general, there is no such thing as "the price" of a good. Rather, every time the good is bought or sold, that transaction is carried out at a price. A priori, it is possible that the prices of the transactions differ for each transaction. At the most micro-level, a price is therefore something that a buyer and seller willingly agree upon in order to carry out a transaction.
In order to be able to talk of a notion of "the price" (even as an approximation to the actual prices of a wide range of transactions) we need to have some idea about the market structure.
- The law of one price says that under certain kinds of market structures (such as competitive markets, zero transaction costs, perfect information, and perfect rationality), prices will be the same throughout the market. The term market price is used to describe such a price.
- Price discrimination refers to a phenomenon where a single seller uses different prices for different buyers.
- Price dispersion refers to variability in prices between sellers.