Price and Price Mechanisms

Price is the value of a good or service in the market. Price mechanisms are strategies that impact and guide consumption by altering the price of the good (or service) relative to its substitutes.

Price is a key component of economic analysis due to its relation with quantity consumed in a demand curve. The term price refers to the market valuation of the good or service, and it does not indicate the specific valuation of the good to the consumer or the producer. Price represents the equilibrium point where demand meets supply, and it corresponds to the value where willingness to pay (WTP) equals willingness to accept (WTA). The importance of price stems from its role as cost to the consumer, and it determines the total amount of goods that he or she can afford to purchase given his or her budget constraint. In fact, consumers with identical preferences decide how much of an item to buy depending on its value (price) and the amount of money they can allocate to the good (the budget constraint).

In the analysis of consumer behavior, the price of a good equates to the sum of the single value of each of its attributes. In particular, from the perspective of Kelvin Lancaster, the amount of each attribute contained in the products in a market represents the equilibrium between the demand and supply of each attribute. Essentially, from this perspective, consumers do not have a demand for a product but the demand for individual attributes that constitute it. The final WTP corresponds to the sum of the valuation of each attribute that characterizes the good, and choices reflect the comparison of different attribute bundles. Consequently, consumers choose the final product that represents the best value for money for the whole set of attributes available.

The importance of price includes not only an economic perspective, but also price plays an important role in the heuristic process of ex ante evaluation of the quality of the good. In fact, since quality is costly to supply, higher prices can be an indication of higher quality, although the price-quality correlation is imperfect (producers manufacturing the same level of quality at the same cost may have different markups). Nevertheless, since price indicates the value of the product in the market, consumers commonly use this information as proxy for quality in markets when this cannot be easily evaluated ex ante. Moreover, prices not only proxy for quality but also influence consumer perception of the good: Hilke Plassmann and colleagues found that price activates the medial orbitofrontal cortex, the area of the brain responsible for the communication of pleasure during an experiential task. Consequently, consumers are driven in the choice of product not only by the highest value for money (i.e., the best quality given a price range), but also they perceive more expensive products as performing better, a mechanism similar to a placebo effect.

To change patterns of consumption, it is possible to intervene to change the market price of the good or service targeted using price mechanisms. These can be made at an institutional level, using taxes or subsidies, or privately, using discounts. These instruments change the price of the good both in absolute [Page 1146]and relative terms: taxes increase the price of a good, making its substitutes relatively cheaper; on the other hand, subsidies and discounts decrease the price of a good, which is now relatively cheaper than its substitutes. Institutional price changes targeting inputs at the manufacturing level work in the same manner, and the value of the tax or subsidy is entirely passed on to consumers: a tax of x units to the manufacturer will determine an increase of the same amount in the price of the final good.

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