Microeconomic Pricing Model: What it is, How it Works

What Is a Microeconomic Pricing Model?

A microeconomic pricing model describes the prices for a good in a particular market as a function of supply and demand. It shows how the quantity of a good increases as the demand (and price) for that good increases.

Microeconomic pricing models illustrate how markets seek equilibrium, guided by supply and demand. It is a basic rendering of an individual market and can be seen as a narrative version of Adam Smith’s "invisible hand."

Key Takeaways

• Microeconomic pricing models show how supply and demand intersect to find an equilibrium price.
• They can be used to extrapolate demand and quantity at various price points, but are most often used to show the basic market-clearing price for a good.
• Microeconomic pricing models were created out of classical economics and work best in markets with perfect competition.

Understanding Microeconomic Pricing Models

Microeconomic pricing models have a basic graph with price on the y-axis and quantity on the x-axis. The supply line and demand line intersect in the middle, showing equilibrium. However, most models plot different price points and overlay multiple demand curves along the supply line to illustrate how growing demand can affect supply.

The demand curve is determined by consumers trying to maximize utility within their budget, while the supply curve is set by firms aiming to maximize profits. The pricing model is based on producing a quantity of goods that maximizes total revenue minus total costs.

Microeconomic pricing models work well with individual markets as they illustrate how the market adjusts to supply and demand. They can also provide insights into market dynamics, such as the steepness of the supply curve indicating rapid market growth.

Limitations of Microeconomic Pricing Models

Microeconomic pricing models have their limitations. They assume that price is the determining factor when all other factors are equal, but in reality, consumers consider many different factors when making purchasing decisions.

These models also work best in markets with perfect or near-perfect competition, where firms sell fungible goods and operate as price takers. However, most markets do not meet these ideal conditions, making microeconomic pricing models overly optimistic.

In reality, the balance of power within a market determines who is more successful in setting prices. Monopoly markets or those heavily influenced by the government confound microeconomic pricing models. They often depict the market as it should be, rather than as it truly is.