CHAPTER-12
PRICE DETERMINATION UNDER PERFECT COMPETITION
INTRODUCTION
In the context of economics,
a market refers to the interaction between buyers and sellers where goods,
services, or resources are exchanged. It is a mechanism through which the
forces of demand and supply interact to determine prices and allocate resources
in an economy.
Essentials of a
Market:
Buyers
and Sellers: A market requires the
presence of both buyers and sellers who participate in the exchange of goods or
services. Buyers demand the products, while sellers supply them.
Exchange: In a market, there is an exchange of goods, services, or
resources between buyers and sellers. This exchange can be in the form of
direct transactions or through intermediaries.
Price
Determination: Markets involve the
determination of prices for the goods or services being exchanged. The
interaction of demand and supply forces helps establish equilibrium prices.
Competition: Competition is a vital characteristic of a market. It
refers to the rivalry among sellers to attract buyers through factors such as
price, quality, innovation, and marketing strategies.
Information
Flow: Efficient markets
require the flow of information between buyers and sellers. This information
includes product details, prices, availability, and other relevant factors that
influence the decision-making process.
Basis for Market
Division:
Geographical
Division: Markets can be
divided based on geographical factors, such as local markets, regional markets,
national markets, or international markets. This division depends on the
location and scope of trade.
Nature
of Goods: Markets can be
categorized based on the nature of the goods or services being exchanged. This
includes markets for consumer goods, industrial goods, agricultural products,
financial instruments, etc.
Time
Dimension: Markets can be
classified based on the time dimension, such as spot markets (immediate
delivery), futures markets (delivery at a future date), or forward markets
(delivery at a specified future date).
Competitive
Structure: Markets can be
divided based on the competitive structure, including perfect competition,
monopoly, monopolistic competition, and oligopoly. Each type represents a
different degree of market concentration and behavior of firms.
Function: Markets can also be categorized based on their function,
such as the stock market, labor market, foreign exchange market, commodity
market, etc. Each serves a specific purpose and facilitates trade in particular
types of goods or resources.
By considering these
different bases, economists and policymakers can analyze and understand the
dynamics of various markets, their behavior, and the implications for economic
outcomes.
EQUILIBRIUM PRICE
Equilibrium
price, also known as market-clearing price, refers to the price at which the
quantity demanded by buyers equals the quantity supplied by sellers in a
market. It is the price point at which there is no excess demand or excess
supply, resulting in a state of balance in the market.
In
a competitive market, the equilibrium price is determined by the intersection
of the demand and supply curves. At prices above the equilibrium, there is a
surplus of the good as the quantity supplied exceeds the quantity demanded,
which puts downward pressure on the price. Conversely, at prices below the
equilibrium, there is a shortage of the good as the quantity demanded exceeds
the quantity supplied, which pushes the price upwards.
The
equilibrium price plays a crucial role in the efficient allocation of resources
in an economy. It ensures that the goods or services are being produced and
consumed at the optimal level, with neither excess supply nor excess demand. It
represents the price point where buyers and sellers find mutually agreeable
terms for trade.
It's
important to note that the equilibrium price is influenced by various factors,
including changes in demand and supply conditions, consumer preferences,
production costs, government regulations, and external shocks. These factors
can cause shifts in the demand and supply curves, leading to a new equilibrium
price in the market.
PRICE DETERMINATION UNDER PERFECT
COMPETITION
In perfect competition,
price determination is primarily driven by the interaction of demand and supply
forces in the market. The market consists of numerous buyers and sellers who
are price takers, meaning they have no individual control over the market price
and must accept the prevailing price.
The following factors
contribute to price determination under perfect competition:
Large
Number of Buyers and Sellers: In a perfectly competitive market, there are a large
number of buyers and sellers, none of whom have significant market power. Each
buyer and seller is a price taker and has no ability to influence the market
price.
Homogeneous
Products: In perfect
competition, the products sold by different firms are homogeneous, meaning they
are identical in terms of quality, features, and characteristics. Buyers
perceive no difference between the products of different sellers.
Perfect
Information: Buyers and sellers
have perfect and complete information about the market conditions, including
prices, quantities, and quality of goods. This allows them to make informed
decisions and prevents any information asymmetry.
Mobility
of Resources: Resources, such as
labor and capital, are freely movable among different firms in the market. This
ensures that firms can enter or exit the market easily, leading to increased
competition.
Free
Entry and Exit: Firms
can freely enter or exit the market in response to profits or losses. If firms
in the industry are earning profits, new firms will be attracted, which
increases supply and exerts downward pressure on prices. Conversely, if firms
are experiencing losses, some firms may exit the market, reducing supply and
putting upward pressure on prices.
Under perfect competition,
the market price is determined at the point where the demand curve and the
supply curve intersect. At this equilibrium price, the quantity demanded by
buyers is equal to the quantity supplied by sellers, resulting in market
equilibrium. If the price is above the equilibrium, there will be excess
supply, and if it is below the equilibrium, there will be excess demand. As a
result, the market price tends to move towards the equilibrium through the
forces of supply and demand.
It's important to note that
in the long run, under perfect competition, firms earn only normal profits, and
the price is equal to the marginal cost of production. This allocates resources
efficiently and ensures productive efficiency in the market.
EFFECT OF CHANGE IN DEMAND AND SUPPLY
ON EQUILIBRIUM PRICE
Changes in demand and supply
have a significant impact on the equilibrium price in a market. Let's explore
the effects of changes in demand and supply on the equilibrium price:
Change in Demand:
Increase
in Demand: If there is an
increase in demand for a product, the demand curve shifts to the right. This
results in a higher equilibrium price and quantity, as the quantity demanded
exceeds the quantity supplied at the existing price. Producers respond to the
increased demand by increasing production and raising prices.
Decrease
in Demand: If there is a decrease
in demand for a product, the demand curve shifts to the left. This leads to a
lower equilibrium price and quantity, as the quantity demanded is less than the
quantity supplied at the existing price. Producers respond to the decreased
demand by reducing production and lowering prices.
Change in Supply:
Increase
in Supply: If there is an
increase in supply of a product, the supply curve shifts to the right. This
results in a lower equilibrium price and a higher equilibrium quantity, as the
quantity supplied exceeds the quantity demanded at the existing price.
Producers respond to the increased supply by offering more of the product at
lower prices.
Decrease
in Supply: If there is a
decrease in supply of a product, the supply curve shifts to the left. This
leads to a higher equilibrium price and a lower equilibrium quantity, as the
quantity supplied is less than the quantity demanded at the existing price.
Producers respond to the decreased supply by reducing the quantity offered and
raising prices.
It's important to note that
the magnitude of the shift in the demand or supply curve determines the extent
of the price and quantity changes. If the change in demand or supply is
significant, it can result in substantial shifts in the equilibrium price and
quantity. However, if the change is relatively small, the impact on the equilibrium
may be relatively minor.
The simultaneous analysis of
changes in both demand and supply is crucial to fully understand the effect on
the equilibrium price. If both demand and supply increase or decrease
simultaneously, the impact on the equilibrium price will depend on the relative
magnitude of the shifts in the demand and supply curves.
Overall, changes in demand
and supply disrupt the existing equilibrium and lead to adjustments in the
equilibrium price to achieve a new balance between quantity demanded and
quantity supplied in the market.
ROLE OF TIME ELEMENT IN PRICE
DETEMINATION OR THEORY OF VALUE
The time element plays a
crucial role in the determination of prices and the theory of value. Here are
some key aspects of the role of time in price determination:
Price Adjustment:
Short
Run: In the short run,
prices are relatively inflexible due to factors such as fixed costs,
contractual obligations, and production constraints. Changes in demand and
supply may initially result in temporary imbalances, but prices may not adjust
immediately.
Long
Run: In the long run,
prices have more flexibility to adjust as producers can modify their production
levels, investments, and resource allocation. Market forces, such as
competition and changes in technology, influence price adjustments over time.
Market Dynamics:
Time allows for market
dynamics to come into play. Changes in demand and supply conditions take time
to be fully reflected in prices. As buyers and sellers adjust their behavior
and expectations based on market conditions, prices gradually respond to
achieve a new equilibrium.
Market participants gather
and analyze information over time, making decisions on production, investment, and
consumption. The flow of information and its assimilation in the market affects
price determination.
Production and Supply:
Time is essential for
production and supply decisions. Producers need time to adjust their production
levels, expand or contract capacity, and respond to changes in input costs and
market demand. The time required to produce goods and services influences the
quantity supplied and, subsequently, the prices.
Future Expectations:
The time element affects
price determination through future expectations. Buyers and sellers consider
future market conditions, such as anticipated changes in demand, supply, costs,
and competition, when making pricing decisions. These expectations influence
current prices and market outcomes.
Value Assessment:
Time also impacts the
assessment of value. The perception of value varies over time, influenced by
factors such as changing consumer preferences, technological advancements, and
market trends. Buyers and sellers evaluate the worth of goods and services differently
over time, which can affect price determination.
Overall, the role of time in
price determination acknowledges the dynamic nature of markets and the
adjustments that occur over time. Prices respond to changes in demand, supply,
production, and expectations, reflecting the evolving equilibrium between
buyers and sellers in the market.
MARKET PERIOD PRICE DETERMINATION
Market period refers to a
very short time frame in which the supply of a product is fixed and cannot be
increased or decreased. In this period, the price determination is mainly
influenced by the demand for the product. Here are the key characteristics and
factors affecting price determination in the market period:
Characteristics of
Market Period:
Fixed
Supply: The supply of the
product is fixed and cannot be adjusted in the market period. Producers cannot
increase or decrease their output levels within this short time frame.
Inelastic
Supply: Since the supply is
fixed, it is considered highly inelastic in the market period. Producers cannot
respond to changes in demand by adjusting their production levels.
Factors Affecting
Price Determination in the Market Period:
Demand: The primary factor influencing price determination in the
market period is the demand for the product. If the demand exceeds the
available supply, prices tend to rise. Conversely, if the demand is lower than
the available supply, prices may fall.
Urgency
of Demand: The urgency or
necessity of the product can also impact its price in the market period. If the
product is in high demand and there is limited availability, prices are likely
to increase due to the urgency of buyers to acquire the product.
Market
Conditions: Other market
conditions, such as competition and market power of sellers, can also affect
price determination in the market period. In a monopolistic or oligopolistic
market, sellers may have more control over prices, which can influence the
price levels.
Perishable
Goods: In the case of
perishable goods, such as fresh produce or flowers, the limited shelf life or
short expiration period can affect price determination. As the product's
quality deteriorates over time, prices may be adjusted to sell the goods
quickly and avoid spoilage.
It is important to note that
the market period is a theoretical concept and may not accurately represent
real-world markets. In reality, markets often operate in longer time frames,
allowing for adjustments in supply and price determination based on changing
market conditions.
SHORT PERIOD PRICE DETERMINATION
Short-period price
determination refers to the process by which prices are established in the
short run, taking into account both demand and supply conditions. In the short
run, some factors of production, such as plant capacity and technology, remain
fixed, while others, like labor and raw materials, can be adjusted to some
extent. Here are the key factors and considerations in short-period price
determination:
Market
Demand: The level of demand
for a product plays a crucial role in determining its price in the short period.
If demand increases, it puts upward pressure on prices, while a decrease in demand
may lead to lower prices.
Market
Supply: The available supply
of a product in the short period also affects its price. If the supply is
limited or fixed, prices are likely to be higher, while a surplus of supply may
result in lower prices.
Cost
of Production: The cost of
production has a significant influence on price determination. In the short
run, fixed costs (such as rent and capital investment) remain constant, while
variable costs (such as labor and raw materials) can be adjusted. If the cost
of production increases, it may lead to higher prices, while lower production
costs can result in lower prices.
Market
Structure: The market structure,
such as perfect competition, monopoly, or monopolistic competition, can affect
price determination. In perfectly competitive markets, prices are determined by
the interaction of supply and demand. In monopolistic markets, a firm with
market power can set prices to maximize its profits.
Industry-specific
Factors: Factors specific to
the industry or market, such as government regulations, taxes, subsidies, or
technological advancements, can impact short-period price determination. These
factors can affect costs, supply levels, and market competition, ultimately
influencing prices.
It's important to note that
short-period price determination is subject to dynamic changes and is
influenced by various economic factors. Over time, as the market adjusts and
factors of production become more flexible, the equilibrium price may change in
response to shifts in demand and supply conditions.
NORMAL PRICE AND LAWS OF RETURNS TO
SCALE
Normal Price:
The normal price refers to
the long-term average price of a product or service in a market. It is the
price at which demand and supply are in equilibrium over an extended period,
considering all relevant factors. The normal price is influenced by various
factors such as production costs, market competition, technology, and consumer
preferences. It serves as a benchmark or reference point around which actual
prices may fluctuate in the short run.
Laws of Returns to
Scale:
The laws of returns to scale
are economic principles that describe the relationship between inputs and
outputs in production. These laws examine how changes in the scale of
production, such as increasing the quantity of inputs, impact the level of
output. There are three main laws of returns to scale:
Increasing
Returns to Scale: This
law states that when all inputs are increased by a certain proportion, output
increases at a higher rate. In other words, a proportionate increase in inputs
leads to a more than proportionate increase in output. This can occur when
there are economies of scale, such as better utilization of resources, specialization,
or improved efficiency.
Constant
Returns to Scale: This
law states that when all inputs are increased by a certain proportion, output
increases at the same rate. In other words, the proportionate increase in
inputs results in a proportionate increase in output. This occurs when the
production process exhibits constant efficiency and there are no significant
economies or diseconomies of scale.
Decreasing
Returns to Scale: This
law states that when all inputs are increased by a certain proportion, output
increases at a lower rate. In other words, a proportionate increase in inputs
leads to a less than proportionate increase in output. This can occur when
there are diseconomies of scale, such as diminishing returns, increased
coordination challenges, or inefficiencies in the production process.
The laws of returns to scale
help to understand the relationship between input levels and output levels as
production scales up or down. These laws have implications for cost structures,
production efficiency, and the optimal size of operations in various
industries.
COMPARISON BETWEEN MARKET PRICE AND
NORMAL PRICE
Market Price:
Determined by the forces of
demand and supply in the market.
Can fluctuate in the short
run due to changes in factors such as demand, supply, and market conditions.
Represents the prevailing
price at a given point in time.
May deviate from the normal
price due to temporary factors such as seasonality, scarcity, or changes in
market conditions.
Market price reflects the
interaction of buyers and sellers in the marketplace.
Normal Price:
Represents the long-term
average price of a product or service.
Takes into account factors
such as production costs, competition, technology, and consumer preferences.
Considers the equilibrium
between demand and supply over an extended period.
Serves as a benchmark or
reference point for actual prices in the long run.
Normal price provides a more
stable and predictable measure of the value of a product or service.
Comparison:
Determination: Market price is determined by the immediate forces of
demand and supply, while normal price is influenced by long-term equilibrium
factors.
Stability: Market price is more volatile and subject to short-term
fluctuations, whereas normal price is relatively stable over time.
Timeframe: Market price reflects the current conditions in the
market, whereas normal price represents a long-term average.
Reference
point: Market price can
deviate from the normal price in the short run, but over time, market forces
tend to bring prices closer to the normal price.
Market
dynamics: Market price is
influenced by the interaction of buyers and sellers in the marketplace, whereas
normal price considers broader economic and industry factors.
In summary, market price
represents the current price determined by immediate market forces, while
normal price represents the long-term average price considering various
equilibrium factors. Market price is more volatile and subject to short-term
changes, while normal price provides a more stable measure of the value of a
product or service over time.
VERY SHORT QUESTIONS
Q.1.What do you mean by equilibrium
price?
Ans. Equilibrium price refers to the price at which the
quantity demanded of a product or service is equal to the quantity supplied,
resulting in a state of balance in the market.
Q.2.How has Marshall defined
equilibrium price?
Ans. Marshall has defined equilibrium price as "market
price at which the quantity of a commodity demanded is equal to the quantity
supplied."
Q.3. What will happen to price and
output if demand of a commodity increases, supply remaining the same?
Ans. Price: Increase
Output: Increase
Q.4.What will happen to price and
output if supply of a commodity increases, demand remaining the same?
Ans. Price: Decrease
Output: Increase
Q.5. How is price affected by fall in
supply?
Ans. Price: Increase
Q.6. How is price affected by fall in
demand?
Ans. Price: Decrease
Q.7.What is market price?
Ans. Market Price: The prevailing price of a product or
service in the marketplace.
Q.8.What is natural or
normal price or long run price?
Ans. Natural Price/Normal Price/Long Run Price: The average
price of a product or service in the long run, considering factors such as
production costs, competition, and equilibrium between demand and supply.
Q.9. Who determines price under perfect
competition?
Ans. Under perfect competition, price is determined by the
interaction of market forces, specifically the forces of demand and supply.
Q.10.What does firm determine under
perfect competition?
Ans. Under perfect competition, a firm determines the quantity
of output it wants to produce based on its cost structure and profit
maximization objective. However, the firm does not have control over the price,
as it is a price taker and must accept the prevailing market price.
Q.11.The price that is determined
during very short period is called?
Ans. The price that is determined during a very short period
is called the market period price.
SHORT QUESTIONS ANSWER
Q.1. briefly explain the equilibrium
price determination under perfect competition?
Ans. In perfect competition, the equilibrium price is
determined by the interaction of demand and supply in the market. The
equilibrium price is the price at which the quantity demanded by consumers is
equal to the quantity supplied by producers.
The process of equilibrium
price determination begins with the establishment of a market where numerous
buyers and sellers participate. Each buyer and seller in the market is a price
taker, meaning they have no control over the market price and must accept it as
given.
Initially, the market starts
with a certain price level. If the market price is above the equilibrium price,
there will be excess supply as producers are willing to supply more than what
consumers demand at that price. In response, producers lower their prices to
attract more buyers. This leads to an increase in quantity demanded and a
decrease in quantity supplied until the equilibrium is reached.
On the other hand, if the
market price is below the equilibrium price, there will be excess demand as
consumers are willing to buy more than what producers are supplying at that
price. In response, producers raise their prices to take advantage of the
higher demand. This leads to a decrease in quantity demanded and an increase in
quantity supplied until the equilibrium is reached.
The equilibrium price is
achieved when the quantity demanded equals the quantity supplied, creating a
state of balance in the market. At this price, there is no tendency for prices
or quantities to change, and the market is in a state of equilibrium.
Overall, under perfect
competition, the equilibrium price is determined by the forces of demand and
supply, ensuring that resources are allocated efficiently and the market
operates in a balanced manner.
Q.2. Show with the help of diagrams the
effect on equilibrium price and quantity when (1) Demand is perfectly elastic
and supply decreases (2) supply is perfectly elastic and demand increases?
Ans. (1) When demand is perfectly elastic and supply decreases:
In this scenario, demand is
perfectly elastic, which means that consumers are extremely sensitive to price
changes. A decrease in supply means that producers are offering fewer goods or
services in the market.
Graphically, the
effect can be shown as follows:
The demand curve is a
horizontal line, indicating perfectly elastic demand.
The initial supply curve
intersects the demand curve at the original equilibrium price and quantity,
labeled as P1 and Q1, respectively.
When the supply decreases,
the supply curve shifts to the left. This shift indicates that the quantity
supplied at each price level has decreased.
As a result, the new
equilibrium is established at a higher price and a lower quantity, labeled as
P2 and Q2, respectively.
The equilibrium price
increases due to the decreased supply, but the quantity traded in the market
decreases.
(2) When supply is
perfectly elastic and demand increases:
In this scenario, supply is
perfectly elastic, which means that producers can increase the quantity
supplied without affecting the price. Demand increases, indicating that
consumers are willing to purchase more goods or services at each price level.
Graphically, the
effect can be shown as follows:
The supply curve is a
horizontal line, indicating perfectly elastic supply.
The initial demand curve
intersects the supply curve at the original equilibrium price and quantity,
labeled as P1 and Q1, respectively.
When demand increases, the
demand curve shifts to the right. This shift indicates that the quantity
demanded at each price level has increased.
As a result, the new
equilibrium is established at the original price and a higher quantity, labeled
as P1 and Q2, respectively.
The equilibrium quantity
increases due to the increased demand, but the price remains the same because
supply is perfectly elastic.
In both cases, the effects
on equilibrium price and quantity are different due to the difference in the
elasticity of demand and supply. When demand is perfectly elastic, the
equilibrium price and quantity are significantly affected by changes in supply.
Conversely, when supply is perfectly elastic, changes in demand have a greater
impact on the equilibrium quantity traded while the price remains constant.
Q.3. Differentiate
between market price and normal price on different bases?
Ans. The differentiation between market price and normal price
can be understood based on the following factors:
Definition:
Market
Price: Market price refers
to the prevailing price at which a good or service is bought and sold in the
market at a given point in time.
Normal
Price: Normal price, also
known as long-run equilibrium price, refers to the price level that prevails in
the long run when all factors of production are fully adjusted.
Time Period:
Market
Price: Market price is
determined in the short run, where demand and supply conditions fluctuate due
to factors such as consumer preferences, production costs, and market
conditions.
Normal
Price: Normal price is
determined in the long run when all factors of production can be adjusted. It
represents the equilibrium price level after the market has fully adjusted to
changes in supply and demand.
Stability:
Market
Price: Market prices can be
highly volatile and subject to fluctuations in response to changes in supply
and demand conditions, as well as other market factors.
Normal
Price: Normal prices are
relatively stable and represent the equilibrium point where supply and demand
are balanced in the long run.
Factors of Production:
Market
Price: Market prices do not
consider the cost of production or the availability of resources. They are
primarily determined by the interaction of supply and demand in the market.
Normal
Price: Normal prices
consider the cost of production and the availability of resources. They reflect
the long-run equilibrium condition where all factors of production are fully
utilized and their costs are taken into account.
Price Adjustments:
Market
Price: Market prices are
flexible and can adjust quickly in response to changes in supply and demand
conditions, allowing for short-term market equilibrium.
Normal
Price: Normal prices are
relatively inflexible and may take longer to adjust. They represent the
long-run equilibrium point where supply and demand have fully adjusted.
Overall, market prices are
determined by the current supply and demand conditions in the short run, while
normal prices represent the long-run equilibrium that considers the full
adjustment of factors of production and production costs. Market prices tend to
be more volatile and subject to short-term fluctuations, while normal prices
are relatively stable and reflect the long-term equilibrium condition.
Q.4.What is the role of time element in
price determination?
Ans. The time element plays a crucial role in price
determination as it allows for the adjustment of market conditions, supply, and
demand over different periods. Here are some key roles of the time element in
price determination:
Short
Run vs. Long Run: The
time element distinguishes between the short run and the long run. In the short
run, prices are influenced by immediate supply and demand conditions, while in
the long run, prices are influenced by the adjustment of factors such as
production capacity, technology, and resource availability.
Market
Period: In the market period,
which is the shortest time frame, prices are determined solely by the
interaction of demand and supply at a given moment. There is limited scope for
adjustments in production or resource allocation.
Adjustment
Process: The time element
allows for the adjustment process to occur. In the short run, prices may
fluctuate due to temporary imbalances in supply and demand, but over time,
market forces work to bring prices closer to equilibrium.
Market
Equilibrium: The time element is
essential for the achievement of market equilibrium. In the long run, prices
adjust to balance supply and demand, ensuring that resources are allocated
efficiently. The time element allows for the necessary adjustments to occur,
such as changes in production levels, entry or exit of firms, and shifts in
consumer preferences.
Future
Expectations: The time element also
incorporates future expectations into price determination. Buyers and sellers
consider anticipated changes in supply, demand, and market conditions, which
can influence their pricing decisions.
Overall, the time element in
price determination acknowledges that markets are not static, and supply and
demand conditions can change over time. It allows for the adjustment of prices
and resource allocation, leading to market equilibrium in the long run
Q.5. How the laws of returns affect the
normal price?
Ans. The laws of returns, specifically the Law of Diminishing
Returns and the Law of Increasing Returns, can affect the normal price in the
following ways:
Law
of Diminishing Returns: According
to the Law of Diminishing Returns, as successive units of a variable input are
added to a fixed input, the marginal product of the variable input will
eventually diminish. This means that the additional output produced by each
additional unit of input will decrease.
In terms of the normal
price, the Law of Diminishing Returns can lead to an increase in production
costs. As more units of input are added, the marginal cost of production tends
to rise. This can result in a higher normal price as producers need to cover the
increased costs associated with diminishing returns.
Law
of Increasing Returns: The
Law of Increasing Returns states that as more units of a variable input are
added to a fixed input, the marginal product of the variable input increases.
This means that the additional output produced by each additional unit of input
will increase.
In relation to the normal
price, the Law of Increasing Returns can lead to a decrease in production
costs. As more units of input are added, the marginal cost of production tends
to decrease. This can result in a lower normal price as producers can achieve
economies of scale and cost efficiencies.
It is important to note that
the impact of the laws of returns on the normal price depends on various
factors such as the specific industry, market conditions, and the availability
of inputs. Additionally, other factors such as demand and market competition
also play a role in determining the final normal price.
LONG QUESTIONS ANSWER
Q.1. Explain with the help and diagram
the determination of equilibrium price of a commodity under perfect
competition?
Ans. In a perfectly competitive market, the equilibrium price
of a commodity is determined by the intersection of the demand and supply
curves. Let's explain the process using a diagram:
Draw
the demand curve: The
demand curve represents the quantity of the commodity that consumers are
willing and able to buy at different price levels. It slopes downward from left
to right, indicating that as the price increases, the quantity demanded decreases.
Draw
the supply curve: The
supply curve represents the quantity of the commodity that producers are
willing and able to supply at different price levels. It slopes upward from
left to right, indicating that as the price increases, the quantity supplied
also increases.
Identify
the equilibrium point: The
equilibrium price is the price at which the quantity demanded equals the
quantity supplied. It is the point where the demand and supply curves
intersect.
Determine
the equilibrium price: The
price at the intersection of the demand and supply curves is the equilibrium
price. This is the price at which there is no excess demand or excess supply in
the market.
Read
the equilibrium quantity: Once
the equilibrium price is determined, you can read the corresponding quantity on
either the demand or supply curve at that price. This is the equilibrium
quantity, which represents the quantity of the commodity that will be bought
and sold in the market at the equilibrium price.
It's important to note that
the equilibrium price and quantity may adjust over time as factors such as
changes in demand or supply conditions occur. However, in a perfectly
competitive market, the forces of demand and supply will eventually bring the
market back to the equilibrium price.
Q.2.What do you mean by equilibrium
price? How do the forces of demand and supply affect the equilibrium price?
Ans. The equilibrium price is the price at which the quantity
demanded by consumers equals the quantity supplied by producers in a market. It
is the point where there is no surplus or shortage of the commodity.
The forces of demand
and supply interact to determine the equilibrium price:
Demand: The demand curve represents the willingness and ability
of consumers to purchase a particular commodity at different price levels. As
the price of a commodity decreases, the quantity demanded tends to increase,
and vice versa. This inverse relationship between price and quantity demanded
is known as the law of demand.
Supply: The supply curve represents the willingness and ability
of producers to sell a particular commodity at different price levels. As the
price of a commodity increases, producers are motivated to supply more of it to
the market, and vice versa. This positive relationship between price and quantity
supplied is known as the law of supply.
When the forces of
demand and supply interact, they determine the equilibrium price:
If the market price is above
the equilibrium price, there is a surplus of the commodity. Producers are
supplying more than what consumers are willing to buy, leading to downward
pressure on the price. As the price decreases, the quantity demanded increases
and the quantity supplied decreases until the equilibrium is reached.
If the market price is below
the equilibrium price, there is a shortage of the commodity. Consumers are
demanding more than what producers are supplying, leading to upward pressure on
the price. As the price increases, the quantity demanded decreases and the
quantity supplied increases until the equilibrium is reached.
The forces of demand and
supply continually interact to adjust the price towards the equilibrium level,
ensuring that the market reaches a state of balance where the quantity demanded
equals the quantity supplied.
Q.3. Define normal price how do laws of
returns affect the determination of normal price?
Ans. The normal price, also known as the long-run equilibrium
price or the natural price, is the price at which the quantity demanded equals
the quantity supplied in the long run, taking into account all the costs of
production. It is the price level that prevails when all factors of production
are fully employed and there are no temporary disturbances in the market.
The determination of
the normal price is influenced by the laws of returns, which include the law of
diminishing returns and the law of increasing returns:
Law
of Diminishing Returns: According
to this law, as more units of a variable input (e.g., labor) are added to a
fixed input (e.g., capital), the marginal product of the variable input will
eventually decrease. In other words, there is a diminishing marginal return. As
a result, the cost of producing additional units of output increases, which
tends to push the normal price higher.
Law
of Increasing Returns: This
law states that in some cases, as more units of a variable input are added to a
fixed input, the marginal product of the variable input may increase. This can
occur when there are economies of scale or when technological advancements
improve productivity. In such situations, the cost of producing additional
units of output decreases, which tends to push the normal price lower.
The laws of returns
influence the determination of the normal price by affecting the cost structure
of production. If the law of diminishing returns dominates, the cost per unit
of output tends to increase, leading to a higher normal price. Conversely, if
the law of increasing returns dominates, the cost per unit of output tends to
decrease, resulting in a lower normal price.
Overall, the normal price is
determined by the interaction of costs, productivity, and market conditions in
the long run. It reflects a state of equilibrium where producers earn normal
profits, and it serves as a benchmark for the market price to gravitate towards
in the long run.
Q.4. Explain the role of time element
in the determination of price under perfect competition?
Ans. In perfect competition, the role of the time element in
the determination of price is crucial. Perfect competition assumes that there
are numerous buyers and sellers in the market, and no single participant has
the power to influence prices. Instead, prices are determined by the
interaction of market forces, including supply and demand.
The time element plays a
significant role in two aspects: the short run and the long run.
Short
Run: In the short run, the
time period is relatively brief, and some factors of production, such as plant
and machinery, cannot be easily varied. In this time frame, prices are
primarily determined by the interplay of supply and demand. The quantity of
output supplied by firms is influenced by their existing production capacity,
which includes fixed factors that cannot be changed in the short run. As a
result, the supply curve is relatively inelastic. Any changes in demand,
whether it's an increase or decrease, will have a more substantial impact on
prices rather than on the quantity supplied. For example, if demand increases,
the price will rise because the existing firms cannot quickly increase
production to meet the higher demand. Conversely, if demand decreases, the
price will decrease because firms are still operating at their existing
capacity and need to sell their output.
Long
Run: In the long run, the
time period is more extended, allowing firms to adjust all factors of
production, including plant size, labor, and technology. Firms have the
flexibility to enter or exit the industry, and existing firms can expand or
contract their operations. In the long run, prices are determined by the
interaction of supply and demand, but the supply curve becomes more elastic as
firms can adjust their production levels. If there are profits in the industry,
new firms will enter, increasing the supply and putting downward pressure on
prices. Conversely, if there are losses, firms may exit the industry, reducing
supply and causing prices to rise. In the long run, prices will settle at a
level where firms make zero economic profits, known as the equilibrium price.
In summary, the time element
in perfect competition affects price determination by considering the short-run
constraints on production capacity and the long-run adjustments that firms can
make to their operations. Prices in the short run are more influenced by demand
changes, while prices in the long run are influenced by the entry and exit of firms
based on their profitability.
Q.5. If the demand and supply of a
commodity both increase the equilibrium price may not change, may increase
Explain using diagrams?
Ans. To illustrate the scenario where both demand and supply
of a commodity increase but the equilibrium price may not change or may
increase, we can refer to the diagram of supply and demand.
In the diagram, the vertical
axis represents price, and the horizontal axis represents quantity. The demand
curve slopes downward from left to right, indicating the relationship between
price and quantity demanded, while the supply curve slopes upward, representing
the relationship between price and quantity supplied.
Initially, let's assume the
demand curve is D1 and the supply curve is S1, intersecting at point A,
representing the initial equilibrium price (P1) and quantity (Q1).
Now, if both demand and
supply increase, the demand curve shifts to the right (D2) due to increased
consumer demand, and the supply curve also shifts to the right (S2) due to increased
production. However, the extent of the shifts and their relative magnitudes
will determine the outcome.
Case 1: Equilibrium
price may not change:
If the increase in demand is
relatively equal to the increase in supply, the new demand curve (D2) and
supply curve (S2) will intersect at point B. In this case, the equilibrium
price (P1) remains unchanged, while the equilibrium quantity increases from Q1
to Q2. The simultaneous increase in demand and supply offsets each other,
resulting in the same price level but a higher quantity.
Case 2: Equilibrium
price may increase:
If the increase in demand is
relatively greater than the increase in supply, the new demand curve (D2) and
supply curve (S2) will intersect at point C. In this case, the equilibrium price
(P1) increases, and the equilibrium quantity also increases from Q1 to Q3. The
increase in demand has a stronger impact than the increase in supply, leading
to a higher price level along with a larger quantity.
The diagram demonstrates
that when both demand and supply of a commodity increase, the equilibrium price
may remain unchanged or increase depending on the relative magnitude of the
shifts in the curves. The interplay between changes in demand and supply
determines the new equilibrium point, reflecting the balancing effect of market
forces.
