Price Determination in Different Markets

CA Foundation Business Economics Study Material Chapter 4 Price Determination in Different Markets – Determination of Prices

Determination of Equilibrium Price

• We know that law of demand reveals, if other conditions remain unchanged, more quantity of a commodity is demanded in the market at a lower price and less quantity is demanded at a higher price. Therefore, demand curve slopes downward.
• Similarly, the law of supply reveals, if other conditions remain unchanged, more quantity of a commodity is supplied in the market at a higher price and less quantity is supplied at a lower price. Therefore, supply curve slopes upward.
• Demand and supply are the two main factors that determine the price of a commodity in the market. In other words, the price of a commodity is determined by the inter-action of the forces of demand and supply.
• The price that will come to prevail in the market is one at which quantity demanded equals 1 quantity supplied.
• This price at which quantity demand equals quantity supplied is called equilibrium price.
• The quantity demanded and supplied at equilibrium price is called equilibrium quantity.

The process of price determination is illustrated with the help of following imaginary schedule and diagram.

The above table shows that at a price of ₹ 3 per unit, the quantity demanded equals quantity supplied of the commodity. At ₹ 3 two forces of demand and supply are balanced. Thus, ₹ 3 is the equilibrium price and equilibrium quantity at ₹ 3 is 300 units.

• The equilibrium between demand and supply can also be explained graphically as in Fig.
• In Fig. the market is at equilibrium at point ‘E’, where the demand curve and supply curve intersect each other. Here quantity demanded and supplied, are equal to each other.
• At point ‘E’, the equilibrium price is ₹ 3 per unit and equilibrium quantity is 300 units.
• If the price rises to ₹ 4 per unit, the supply rises to 400 units but demand falls to 200 units. Thus, there is excess supply of 200 units in the market.
• In order to sell off excess supply of 200 units the sellers will compete among themselves and in doing so the price will fall.
  As a result the quantity demand will rise and quantity supplied will fall and becoming equal to each other at the equilibrium price ₹ 3.
• Similarly, if the price falls to ₹ 2 per unit, the demand rises to 400 units but supply falls to 200 units. Thus, there is excess demand of 200 units in the market.
• As the price is less there is competition among the buyers to buy more and more. This competition among buyers increases with the entry of new buyers.
• More demand and less supply and competition among buyers will push up the price.
• As a result, quantity demanded will fall and quantity supplied will rise and become equal to each other at the equilibrium price of ₹ 3.

Effects of Shifts in Demand and Supply on Equilibrium Price

While determining the equilibrium price, it was assumed that demand and supply conditions were constant. In reality however, the condition of demand and supply change continuously.
Thus, changes in income, taste and preferences, changes in the availability and prices of related goods, etc. brings changes in demand conditions and cause demand curve to shift either to right or left.
In the same way, changes in the technology, changes price of labour, raw materials, etc., changes in the number of firms, etc. brings changes in supply conditions and cause supply curve to shift either to right or left.

(a) Change (shift) in Demand and Supply remaining constant.

• In Fig.- DD and SS are the original demand and supply curves respectively intersecting each other at point E.
• At point E, the equilibrium price is OP and the demand and supply (ie. equilibrium quantity) are equal at OQ.
• When the demand increases, the demand curve shifts upwards from DD to D₁D₁ supply remaining the same.
  As a result, the equilibrium price rises from OP to OP₁ and the equilibrium quantity increases from OQ to OQ₁ as shown at point E₁.
• When the demand decreases, the demand curve shifts downwards from DD to D₂D₂, Supply remaining the same.
• As a result, the equilibrium price falls from OP to OP₂ and the equilibrium quantity decreases from OQ to OQ₂ as shown at point E₂.

(b) Change (shift) in Supply and Demand remaining constant.

• In Fig. – DD and SS are the original demand and supply curves respectively inter-sections each other at point E.
• At point E, the equilibrium price is OP and the demand and supply (i.e. Equilibrium quantity) are equal at OQ.
• When the supply increases, the supply curve shifts to the right from SS to S₁S₁ demand remaining the same.
• As a result, the equilibrium price falls from OP to OP₁ and the equilibrium quantity increases from OQ to OQ₁ as shown at point E₁.
• When the supply decreases, the supply curve shifts to the left from SS to S₂S₂, demand remaining the same.
• As a result, the equilibrium price rises from OP to OP₂ and the equilibrium quantity decreases from OQ to OQ₂ as shown at point E₂.

Effects of Simultaneous Shifts in Demand and Supply on Equilibrium Price

Sometimes demand and supply conditions may change at the same time changing the equilibrium price and quantity. The changes in both demand and supply simultaneously can be discussed with the help of following diagrams:

• In Fig. – DD and SS are the original demand and supply respectively intersecting each other at point E at which the equilibrium price is OP and the equilibrium quantity is OQ.
• Fig. (a) shows that the increase in demand is equal to increase in supply. The new curves D₁D₁ and S₁S₁ intersect at E₁. Therefore, the new equilibrium price is equal to old equilibrium price OP. But equilibrium quantity increases.
• Fig. (b) shows that the increase in demand is more than increase in supply. The new curves D₁D₁ and S₁S₁ intersect each other at point E, which shows that new equilibrium price OP₁ is higher than old equilibrium price OP. But equilibrium quantity increases.
• Fig. (c) shows that the increase in supply is more than increase in demand. The new curves D₁D₁ and S₁S₁ intersect each other at point E₁ which shows that new equilibrium price OP₁ is lower than old equilibrium price OP. But equilibrium quantity increases.

CA Foundation Business Economics Study Material Chapter 4 Price Determination in Different Markets – Meaning and Types of Markets

MEANING OF MARKET

• In ordinary language, a market refers to a place where the buyers and sellers of a commodity gather and strike bargains.
• In economics, however, the term “Market” refers to a market for a commodity. E.g. Cloth market; furniture market; etc.
  According to Chapman, “the term market refers not necessarily to a place and always to a commodity and buyers and sellers who are in direct competition with one another”.
• According to the French economist Cournot, “Market is not any particular place in which things are bought and sold, but the whole of any region in which buyers and sellers are in such free intercourse with each other that the prices of the same goods tend to equality easily and quickly”,

The above mentioned definitions reveals the following features of a market:

1. A region. A market does not refer to a fixed place. It covers a region, which may be a town, state, country or even world.
2. Existence of buyers and sellers. Market refers to the network of potential buyers and sellers who may be at different places.
3. Existence of commodity or service. The exchange transactions between the buyers and sellers can take place only when there is a commodity or service to buy and sell.
4. Bargaining for a price between potential buyers and sellers.
5. Knowledge about market conditions. Buyers and sellers are aware of the prices offered or accepted by other buyers and sellers through any means of communication.
6. One price for a commodity or service at a given time.

Classification of Market:

Markets may be classified on the basis of different criteria. In Economics, generally the classification is made as pointed out in the following chart—

TYPES OF MARKET STRUCTURES

Market can be classified on the basis of area, volume of business, time, status of sellers, regulation and control.
The main types of markets can be summed up as follows:

1. Perfect Competition:
   • Perfect competition market is one where there are many sellers selling identical products to many buyers at a uniform.
2. Monopoly:
   • Monopoly market structure is a market situation in which there is a single seller of a commodity selling to many buyers.
   • The commodity has no close substitutes available.
   • A monopolist therefore, has a considerable influence on the price and supply of his commodity.
3. Monopolistic Competition:
   • Monopolistic competition is a market situation in which there are many sellers selling differentiated goods to many buyers.
4. Oligopoly:
   Oligopoly is a market situation in which there are few sellers selling either homogeneous or differentiated goods.

Table: Features of major types of markets

Points	Market Types
	Perfect Competition	Monopoly	Monopolistic Competition	Oligopoly
i. Number of sellers	Many	One	Many	Few
ii. Product	Homogeneous	Unique having no substitutes	Differentiated	Homogeneous or Differentiated
iii. Selling Cost	No	Negligible	High	High
iv. Degree of control over price	No Control. Price taker.	Full control. Price maker	Limited due to product differentiation.	Limited
v. Demand (or AR) Curve	Horizontal straight line parallel to x-axis	Downward sloping	Downward sloping	Indeterminate
vi. Price elasticity of demand	Infinite P = MC	Small P > MC	Large P > MC	Small

CONCEPTS OF TOTAL REVENUE, AVERAGE REVENUE AND MARGINAL REVENUE

Total Revenue: (TR)

• Total revenue may be defined as the total amount of money received by the firm by selling a certain units of a commodity.
• It is obtained by multiplying the price per unit of a commodity with the total number of units sold.
• Total Revenue = Price per unit X Total No. of units sold
  TR = P X Q
• E.g. A firm sells 100 units of a commodity @ ₹ 15 each, then its total revenue is ₹ 15 X 100 units = ₹ 1,500

Average Revenue: (AR)

• Average revenue is the revenue per unit of the commodity sold.
• It is simply the total revenue divided by the number of units of output sold.
  
• E.g. A firm earns total revenue of ₹ 2,000 by the sale of 100 units of a commodity, then its average revenue is ₹ 20 (₹ 2000 -MOO units)
• By definition average revenue is the price per unit of output. To prove it
  

Marginal Revenue (MR):

• Marginal revenue refers to the addition to total revenue by selling one more unit of a commodity.
• Marginal revenue may also be defined as the change in total revenue resulting from the sale of one more unit of a commodity
• E.g. If a firm sells 100 units of a commodity @ ₹ 15 each, its TR is ₹ 1,500. Now, if it increases the sale by ten units i.e. it sells 110 units @ ₹ 14 each, its TR is ₹ 1,540. Thus,
  
  Where
  ∆TR is the change in total revenue
  ∆Q is the change in the quantity sold
• For one unit change – MR_n = TR_n – TR_n-1
  Where
  MR_n = Marginal Revenue from ‘n’ units
  TR_n = Total Revenue of ‘n’ units
  TR_n-1 = Total Revenue from ‘n-1’ units
  n = any give number

MARGINAL REVENUE, AVERAGE REVENUE, TOTAL REVENUE AND ELASTICITY OF DEMAND

The relationship between AR, MR and price elasticity of demand can be examined with the formula —


Figure: The relationship between AR, MR, TR & elasticity of demand.

The above figure reveals the following on a straight line demand curve (or AR curve):

1. When e > 1, marginal revenue is positive and therefore total revenue is rising,
2. When e = l, marginal revenue is zero and therefore total revenue is maximum, and
3. When e < l, marginal revenue is negative and therefore total revenue is falling.

BEHAVIOURAL PRINCIPLES

Principle 1: A firm should not produce at all if its total revenue is either equal to or less than its total variable cost.
Principle 2: It will be profitable for the firm to expand output so long as marginal revenue is more than marginal cost till the point where marginal revenue equals marginal cost.
Also the marginal cost curve should cut its marginal revenue curve from below.