Fundamentals of price theory

This chapter introduces the foundational economic principles underlying price-response functions, which are crucial for effective pricing decisions. Through a simplified two-good model, it illustrates key concepts from consumer theory—such as indifference curves, budget constraints, and utility maximization—to show how consumers allocate limited income across goods. These preferences, combined with budget constraints, shape the price-response function. The chapter also covers the aggregation of individual demand into total market demand and introduces the concept of consumer surplus as a measure of consumer benefit. On the cost side, it differentiates between fixed, variable, and sunk costs, emphasizing the importance of marginal cost in pricing decisions. A step-by-step example demonstrates how to determine the profit-maximizing price by equating marginal revenue and marginal cost. The chapter concludes by examining how market structures—from perfect competition to monopoly—influence a firm’s pricing power and strategy. The tools and frameworks provided lay the groundwork for more advanced pricing analytics discussed in subsequent chapters. Excel-based examples accompany the theoretical material presented in Chapter 2 .