Microeconomic Pricing Model

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. Microeconomic pricing models are basic renderings of an individual market, showing how the quantity of a good increases as the demand (and therefore the price) for that good increases. Microeconomic pricing models illustrate how individual markets seek out equilibrium. The search for equilibrium in the price of a good and the quantity supplied as a theory is part of classical economics. Although it was not illustrated in terms of supply and demand curves with points of price equilibrium, Adam Smith's "invisible hand" was a narrative version of a microeconomic pricing model showing how supply and demand in a particular market will guide competing participants to an equilibrium price.

Understanding Microeconomic Pricing Models

The most basic microeconomic pricing models have price on the y-axis and quantity on the x-axis. The supply line and the demand line then intersect in the middle of the graph, making a perfect X with equilibrium in the middle. This type of microeconomic pricing model is an oversimplification, of course, and most models plot different price points, overlaying multiple demand curves along the supply line to illustrate how growing demand can move supply upwards in a market with estimate pricing points.

The demand curve in microeconomic pricing models is determined by consumers attempting to maximize their utility, given their budget. The supply curve is set by firms attempting to maximize profits, given their costs of production and the level of demand for their product. To maximize profits, the pricing model is based around producing a quantity of goods at which total revenue minus total costs is at its greatest.

Microeconomic pricing models can work well with individual markets because they simply illustrate how the market adjusts to supply and demand. There can be value in modelling a market this way, however. Depending on the good and market being modelled, for example, the supply line may be quite steep and responsive to price increases. This would suggest a rapidly growing market for a good compared to a shallow curve that may be expected in a more mature product's market.

Limitations of Microeconomic Pricing Models

Microeconomic pricing models almost always come with a caveat. These models focus in on a single market and attempt to capture the points of market equilibrium, but there are several compromises being made in that process. While it is understood that a consumer weighs many different factors when deciding to purchase a good, microeconomic pricing models still assume that, when all other factors are equal, price is the determining factor. The issue is that there are many situations where all other factors are not equal, and therefore the accuracy of a microeconomic pricing model suffers.

Moreover, microeconomic pricing models work best in markets with perfect or near perfect competition. This means the market in question has all the firms selling fungible goods and operating as price takers with low barriers to entry. Not many markets live up to this ideal, so microeconomic pricing models are too idealistic in these cases.

In general, the balance of power within the market determines who is more successful in setting prices. Where there is little competition — a duopoly, for example, in aircraft manufacturing — Boeing Company and Airbus SE have pricing power. Monopoly markets or markets with heavy state influence will also confound many microeconomic pricing models. If you are a free market advocate, microeconomic pricing models often show the market for a particular good as it should be rather than as it actually is.