MCom I Semester Managerial Economics Equilibrium Price Study Material Notes

MCom I Semester Managerial Economics Equilibrium Price Study Material Notes: Meaning and Definition of Equilibrium price Determinations of Equilibrium Price Effect of Changes in Demand and Supply and  Equilibrium price and Quantity Importance of Time Element in the Determination fo Price Relationship Between Market Price and Normal Price Difference Between Market Price and Normal Price

MCom I Semester Business Environment Consumer Protection Study Material Notes

EQUILIBRIUM PRICE

MEANING AND DEFINITION OF EQUILIBRIUM PRICE

The term equilibrium has been borrowed from physics which means a state of balance between various forces acting on a particular entity or body. In economics, the term equilibrium means a state in which there is no tendency out the part of a consumner, firm, an industry or whole of the economy to change.

Equilibrium price is the price at which the forces determining price are in balance. Thus, equilibrium price is the price of a commodity determined by the forces of demand and supply. It is the price at which there is neither shortage nor a surplus of the commodity. It is the price at which the demand equals supply. The term equilibrium price has been defined by Prof. K. E. Boulding as, “The price at which the quantity of commodity that the sellers wish to sell is just equal to the quantity that the buyers wish to buy, is called equilibrium price.”

DETERMINATION OF EQUILIBRIUM PRICE

Demand Force

A commodity is demanded by consumers. They demand it because it satisfies their wants by providing them utility. As per the law of diminishing marginal utility, utility of a commodity goes on declining with every additional unit of consumption. Therefore, a consumer can agree to purchase more quantity of a product only when it is offered to him at a lower price. Every consumer wants to purchase a commodity at minimum price. Maximum price at which he can purchase a commodity, shall be equal to its marginal utility. Demand of a commodity will be more at a lower price and less at a higher price. It can be as follows:

In above diagram, price of the commodity is shown on y-axis and quantity demanded on x-axis. DD is demand curve which explains that the more at lower price and less at higher price. Demand curve slopes downwards to the right. is called market price. As the maximum price at which buyers can agree to purchase a commodity, is equal to its marginal utility and the minimum price at which sellers can agree to sell commodity, is equal to its marginal cost of production, therefore, market price will always be determined between marginal utility and marginal cost. It can be illustrated as follows

In above diagram, price of the commodity has been shown on x-axis and quantity of demand and supply on y-axis. DD is demand curve and SS is supply curve. E is the point at which both the demand and supply curves intersect each other. Price of the commodity will be determined at point E where demand and supply are equal to each other.

2. Explain the effect of changes in demand and supply on equilibrium price.

Ans. Meaning of Equilibrium Price. Equilibirium price is the price determined by the relative forces of demand and supply. It is the price at which both the demand and supply of a commodity are equal.

EFFECT OF CHANGES IN DEMAND AND SUPPLY ON EQUILIBRIUM PRICE AND QUANTITY

(A) Effect of Changes in Demand when Supply Remains Constant. If demand of a commodity increases, demand curve will move to the right. If demand falls, demand curve will move to the left. If supply of the commodity remains constant, changes in its demand will affect its equilibrium price and quantity as under:

(1) If Demand Increases, Both the Equilibrium Price and Quantity will increase. If demand of a commodity increases and its supply remains constant, both the equilibrium price and quantity will increase because the suppliers can get higher price for their products. Refer to diagram A

(2) If Demand Decreases, Both the Equilibrium Price and Quantity will Fall. If demand of commodity decreases and its supply remains constant, both the equilibrium price and quantity will fall because the suppliers can sell the same quantity of their product when they offer it at a lower price. Refer to diagram B.

In both diagrams quantities of demand and supply are shown on x-axis and price of commodity on y-axis. DD is orginal demand curve. SS is original supply curve and E is original equilibrium point. Diagram (A) Demand increases to D, D. New demand curve intersects supply curve at E). It shows that both the price and quantity increase on an increase in demand.

Diagram (B): Demand decreases to DD. New demand curve intersects supply curve at E. It shows that both the price and quantity have decreased on a decrease in a demand.

(B) Effect of Changes in Supply when Demand Remains Constant. If supply of a commodity increases, supply curve will move to the right and if supply decreases, supply will move to the left. Changes in supply will effect the price and quantity as under:

(1) If Supply Increases, the Price will Fall but Quantity will Increase. If supply increases and demand remains constant, its price will fall but quantity will increase. Refer to diagram (A).

(2) If Supply Decreases, the Price will increase but Quantity will Decrease. If supply decreases but demand remains constant, its price will increase but quantity will decrease. Refer to diagram (B).

In both diagrams, quantity of demand and supply are shown on x-axis and price of commodity on y-axis. DD is original demand curve, SS is original supply curve and Eis orginal equilibrium point.

Diagram A. Supply increases to S S. New supply curve curve intersects demand curve at E which is a new equilibrium point. Thus, on an increase in supply, equilibrium price will fall but quantity will increase.

Diagram B. Supply decreases to S S. New supply curve cuts demand curve E which is a new equilibrium point. Thus, on a decrease in supply, equilibrium price will fall but quantity will increase.

(C) Simultaneous Changes in Demand and Supply. Simultaneous changes in demand and supply of commodity affect its equilibrium price and quantity as under:

(1) If Demand Increases and Supply Decreases, Price will Increase Sharply but Quantity will Remain the Same. If the demand of commodity increases and supply decreases, its price will increase sharply because of two causes-(i) decrease in demand and (ii) increase in supply but quantity will remain the same. Refer to diagram A.

(2) If Demand decreases and Supply Increases, the Price will Fall Sharply but Quantity will Remain the Same. If demand of a commodity decreases and supply increases, its price will fall sharply because of two causes : (i) decrease in demand and (ii) increase in supply but quantity will remain the same. Refer to diagram B.

(3) If Both the Demand and Supply Increase or Decrease in the Same Proportion, there will be no Change in Price but Quantity will change. When both the demand and supply move in same direction and same proportion, there will be no change in price but quantity will change. Refer to diagram C and D.

In next diagram quantities of demand and supply are shown on x-axis and E is original point of equilibrium Diagram (A). Demand increases to D D and supply decreases to S S. New curves intersect each other at E. Thus, price increases sharply if there is simultaneous increase in demand and decrease in supply but quantity remains the same.

More. If both the demand and supply of a commodity increase or decrease but in different proportion, price will change. If increase in demand is less than increase in supply, equilibrium price will fall but quantity will increase. If increase in demand is more than increase in supply, both the price and quantity will increase. If decrease in demand is more than decrease in supply, both the price and quantity will fall. If decrease in demand is less than decrease in supply, the price will increase but quantity will decrease. It can be illustrated with the help of diagrams as follows:

In diagram A. Quantities of demand and supply are shown on x-axis and price of commodity on y-axis. DD is original demand curve, SS is original supply curve and E is the original point of equilibrium. Digram Demand increases to DD and supply increases to S S. These new curves intersect each other at E. It shows that price has decreased to P’ because increase in supply is more than that of demand and quantity has increased to Q.

In diagram B. Demand increases to D D and supply increases to SS These new curves intersect each other E. It shows that price has increased to P’ because increase in demand is more than that of supply and quantity has increased to Q!

In diagram C. Demand decreases to 0 0 and supply decreases to SS! These new curves intersect each other at E. Thus, price will increase to P because decrease in demand is less than that of supply. Quantity has decreased to Q.

In diagram D. Demand decreases to D D and supply decreases to SS. These new curves intersect each other at E. Thus, price will increase to P because decrease in demand is less than that of supply. Quantity has decreased to Q.

IMPORTANCE OF TIME ELEMENT IN THE DETERMINATION OF PRICE

Prof. Marshall was the first economist to explain the role of time element in the determination of price. According to Prof. Marshall,”Pricing problem should be treated primarily with the view point of time. In economics, time refers to the supply of commodities.”

He distinguished for time period in pricing (1) very short period or market period, (2) short period, (3) long period, (4) very long or secular period.

(1) Very Short Period or Market Period. According to Prof. Marshall, “Market period is very short period in which supply cannot be increased or decreased to adjust with demand. It is a day-to-day period. Over this period, the price of a commodity is determined by its demand.”

Determination of price of a commodity in very short period depends upon whether the commodity is perishable or durable. A perishable commodity like milk, fish, green vegetables etc. cannot be stored for a long whatsoever may be the price. Thus, price of such a commodity is always determined by its demand If demand increases, price will rise and if demand decreases, price will fall. Refer to diagram  sellers may agree to sell the entire stock. At other level, price may be so low that producers would like to stock entire quantity change according to its price between these two levels. Supply cannot exceed total stock even at the highest price because it cannot be increased during this period. Therefore, important role in very short period is played by demand. Refer to diagram. B.

In above diagrams, quantities of demand and supply are shown on x-axis and price on v-axis. DD is original demand curve, S is original supply curve and B is original price.

Diagram A. Demand increase to D D but supply remains constant. As a result, price increases to P. Now demand decreases to D D but supply still remains constant. As a result, price falls to P’Thus, in very short period, price is determined by the demand alone.

In diagram B. at original price OQ, quantity will be offered for sale and QQ quantity will be kept in stock. Now demand increases to D D. As a result, price increases to PAt this price, entire stock will be offered for sale. Demand decreases to D.D. As a result price will decrease to P. At this price Q2 quantity will be offered for sale in market and Q.Q. quantity will be kept in stock. RP is the reserve price below which producers and selleres will not agree to sell at all.

(2) Short period. Short period is a longer period than market period. In short period, new firms cannot enter into the market and techniques of production cannot be changed. Supply can be increased only upto existing production capacity. George J. Stigler has defined short period as, “Short period is the period within which the rate of supply from given plants is variable but the number and size of plant is fixed.”

In short period also, demand plays more important role in determining the price of a commodity. Supply curve of an individual firm is perfectly inelastic

RELATIONSHIP BETWEEN MARKET PRICE AND NORMAL PRICE

Market Price. The market price is the price determined by the relative forces of demand and supply. It is determined at the point at which both the demand and supply of commodity are equal. It is called equilibrium price also.

Normal Price. Normal price is the price which is determined by cost of production. It is equal to Explict Costs + Normal Profit.

Relationship Between Market Price and Normal Price. Market price and normal price are closely interrelated. Market price represents short tern trend of market while normal price represents long-term trend of market. It can be presented with the help of a diagram as follows:

Above diagram represents that normal price is always in the form of a straight line while market price keeps on fluctuating. It may be more or less or equal to normal price, if the supply of a commodity is more than its demand, market price will be less and if the supply of a commodity is less than its demand, market price will be more. In long run, market price tends to be equal to normal price.

Difference Between Market Price and Normal Price SI. Basis of Market Price