MB0042 – Managerial Economics Semester - I
Assignment Set-I
Q1. Price elasticity of demand depends on various factors. Explain each factor with the help of an example.
Answer.
Elasticity of Demand:
Earlier we have discussed the law of demand and its determinants. It tells us only the direction of change in price and quantity demanded. But it does not specify how much more is purchased when price falls or how much less is bought when price rises. In order to understand the quantitative changes or rate of changes in price and demand, we have to study the concept of elasticity of demand.
Meaning and Definition
The term elasticity is borrowed from physics. It shows the reaction of one variable with respect to a change in other variables on which it is dependent. Elasticity is an index of reaction.
In economics the term elasticity refers to a ratio of the relative changes in two quantities. It measures the responsiveness of one variable to the changes in another variable.
Elasticity of demand is generally defined as the responsiveness or sensitiveness of demand to a given change in the price of a commodity. It refers to the capacity of demand either to stretch or shrink to a given change in price. Elasticity of demand indicates a ratio of relative changes in two quantities.ie, price and demand. According to prof. Boulding. “Elasticity of demand measures the responsiveness of demand to changes in price” 1 In the words of Marshall,” The elasticity (or responsiveness) of demand in a market is great or small according to the amount demanded much or little for a given fall in price, and diminishes much or little for a given rise in price” 2.
Kinds of elasticity of demand
Broadly speaking there are five kinds of elasticity of demand.
They are Price Elasticity, Income Elasticity, Cross Elasticity, Promotional Elasticity and Substitution Elasticity. We shall discuss each one of them in some detail.
- Price Elasticity of Demand
In the words of Prof. Stonier and Hague, price elasticity of demand is a technical term used by economists to explain the degree of responsiveness of the demand for a product to a change in its price.
where Ep is price elasticity
.
It implies that at the present level with every change in price, there will be a change in demand four times inversely. Generally the co-efficient of price elasticity of demand always holds a negative sign because there is an inverse relation between the price and quantity demanded.
Symbolically Ep =
Original demand = 20 units original price = 6 – 00
New demand = 60 units New price = 4 – 00
In the above example, price elasticity is – 6.
The rate of change in demand may not always be proportionate to the change in price. A small change in price may lead to very great change in demand or a big change in price may not lead to a great change in demand. Based on numerical values of the co-efficient of elasticity, we can have the following five degrees of price elasticity of demand.
Different Degree of Price Elasticity of Demand
1. Perfectly Elastic Demand: In this case, a very small change in price leads to an infinite change in demand. The demand curve is a horizontal line and parallel to OX axis. The numerical co-efficient of perfectly elastic demand is infinity (ED=)
- Perfectly Inelastic Demand: In this case, what ever may be the change in price, quantity demanded will remain perfectly constant. The demand curve is a vertical straight line and parallel to OY axis. Quantity demanded would be 10 units, irrespective of price changes from Rs. 10.00 to Rs. 2.00. Hence, the numerical co-efficient of perfectly inelastic demand is zero. ED = 0
- Relative Elastic Demand: In this case, a slight change in price leads to more than proportionate change in demand. One can notice here that a change in demand is more than that of change in price. Hence, the elasticity is greater than one. For e.g., price falls by 3 % and demand rises by 9 %. Hence, the numerical co-efficient of demand is greater than one.
- Relatively Inelastic Demand: In this case, a large change in price, say 8 % fall price, leads to less than proportionate change in demand, say 4 % rise in demand. One can notice here that change in demand is less than that of change in price. This can be represented by a steeper demand curve. Hence, elasticity is less than one.
In all economic discussion, relatively elastic demand is generally called as ‘elastic demand’ or ‘more elastic’ demand while relatively inelastic demand is popularly known as ‘inelastic demand’ or ‘less elastic demand’.
5. Unitary elastic demand: In this case, proportionate change in price leads to equal proportionate change in demand. For e.g., 5 % fall in price leads to exactly 5 % increase in demand. Hence, elasticity is equal to unity. It is possible to come across unitary elastic demand but it is a rare phenomenon.
Out of five different degrees, the first two are theoretical and the last one is a rare possibility. Hence, in all our general discussion, we make reference only to two terms-relatively elastic demand and relatively inelastic demand.
Q.2. A company is selling a particular brand of tea and wishes to introduce a new flavor. How will the company forecast demand for it.
Answer.
Demand Forecasting for a New Product
Demand forecasting for new products is quite different from that for established products. Here the firms will not have any past experience or past data for this purpose. An intensive study of the economic and competitive characteristics of the product should be made to make efficient forecasts.
a) Evolutionary approach
The demand for the new product may be considered as an outgrowth of an existing product. For e.g., Demand for new Taj Tea, which is a modified version of Taj Tea can most effectively be projected based on the sales of the old Tea, the demand for new Taj Tea can be forecasted based on the a sales of the old Taj Tea. Thus when a new product is evolved from the old product, the demand conditions of the old product can be taken as a basis for forecasting the demand for the new product.
b) Substitute approach
If the new product developed serves as substitute for the existing product, the demand for the new product may be worked out on the basis of a ‘market share’. The growths of demand for all the products have to be worked out on the basis of intelligent forecasts for independent variables that influence the demand for the substitutes. After that, a portion of the market can be sliced out for the new product. For e.g., A moped as a substitute for a scooter, a cell phone as a substitute for a land line. In some cases price plays an important role in shaping future demand for the product.
c) Opinion Poll approach
Under this approach the potential buyers are directly contacted, or through the use of samples of the new product and their responses are found out. These are finally blown up to forecast the demand for the new product.
d) Sales experience approach
Offer the new product for sale in a sample market; say supermarkets or big bazaars in big cities, which are also big marketing centers. The product may be offered for sale through one super market and the estimate of sales obtained may be ‘blown up’ to arrive at estimated demand for the product.
e) Growth Curve approach
According to this, the rate of growth and the ultimate level of demand for the new product are estimated on the basis of the pattern of growth of established products. For e.g., An Automobile Co., while introducing a new version of a car will study the level of demand for the existing car.
f) Vicarious approach
A firm will survey consumers’ reactions to a new product indirectly through getting in touch with some specialized and informed dealers who have good knowledge about the market, about the different varieties of the product already available in the market, the consumers’ preferences etc. This helps in making a more efficient estimation of future demand.
These methods are not mutually exclusive. The management can use a combination of several of them, supplement and cross check each other.
Activity: The construction industry registers the changes in the demand for various products required in the industry more visibly. Identify changes in demand for housing and trace the changes in demand for steel, cement etc during the same period.
Q.3. The supply of a product depends on the price. What are the other factors that will affect the supply of a product.
Answer.:
Determinants of Supply
Apart from price, many factors bring about changes in supply. Among them the important factors are:
1. Natural factors: Favorable natural factors like good climatic conditions, timely, adequate, well distributed rainfall results in higher production and expansion in supply. On the other hand, adverse factors like bad weather conditions, earthquakes, droughts, untimely, ill-distributed, inadequate rainfall, pests etc., may cause decline in production and contraction in supply.
2. Change in techniques of production: An improvement in techniques of production and use of modern, highly sophisticated machines and equipments will go a long way in raising the output and expansion in supply. On the contrary, primitive techniques are responsible for lower output and hence lower supply.
3. Cost of production: Given the market price of a product, if the cost of production rises due to higher wages, interest and price of inputs, supply decreases. If the cost of production falls, on account of lower wages, interest and price of inputs, supply rises.
4. Prices of related goods: If prices of related goods fall, the seller of a given commodity offer more units in the market even though, the price of his product has not gone up. Opposite will be the case when the price of related goods rises.
5. Government policy: When the government follows a positive policy, it encourages production in the private sector. Consequently, supply expands. For example granting of subsidies, development rebates, tax concession, etc,. On the other hand, output and supply cripples when the government adopts a negative policy. For example withdrawal of all concessions and incentives, imposition of high taxes, introduction of controls and quota system etc.
6. Monopoly power: Supply tends to be low, when the market is controlled by monopolists, or a few sellers as in the case of oligopoly. Generally supply would be more under competitive conditions.
7. Number of sellers or firms: Supply would be more when there are a large number of sellers. Similarly production and supply tends to be more when production is organized on large scale basis. If rate or speed of production is high, supply expands. Opposite will be the case when number of sellers is less, small scale production and low rate of production.
8. Complementary goods: In case of joint demand, the production & sale of one product may lead to production and sale of other product also.
9. Discovery of new source of inputs: Discovery of new sources of inputs helps the producers to supply more at the same price & vice-versa.
10. Improvements in transport and communication: This will facilitate free and quick movements of goods and services from production centers to marketing centers.
11. Future rise in prices: When sellers anticipate a further rise in price, in that case current supply tends to fall. Opposite will be the case when, the seller expect a fall in price.
Thus, many factors influence the supply of a product in the market. A firm should have a thorough knowledge of all these factors because it helps in preparing its production plan and sales strategy.
The other factor that will affect the supply of a product are:
1. Time period
Time has a greater influence on elasticity of supply than on demand. Generally supply tends to be inelastic in the short run because time available to organize and adjust supply to demand is insufficient. Supply would be more elastic in the long run.
2. Availability and mobility of factors of production
When factors of production are available in plenty and freely mobile from one occupation to another, supply tends to be elastic and vice – versa.
3. Technological improvements
Modern methods of production expand output and hence supply tends to be elastic. Old methods reduce output and supply tends to be inelastic.
4. Cost of production
If cost of production rises rapidly as output expands, then there will not be much incentive to increase output as the extra benefit will be choked off by the increase in cost. Hence supply tends to be inelastic and vice-versa.
5. Kinds and nature of markets
If the seller is selling his product in different markets, supply tends to be elastic in any one of the market because, a fall in the price in one market will induce him to sell in another market. Again, if he is producing several types of goods and can switch over easily from one to another, then each of his products will be elastic in supply.
6. Political conditions
Political conditions may disrupt production of a product. In that case, supply tends to become inelastic.
7. Number of sellers
Supply tends to become more elastic if there are more sellers freely selling their products and vice-versa.
8. Prices of related goods
A firm can charge a higher price for its products, if prices of other products are higher and vice-versa.
9. Goals of the firm
If the seller is happy with small output, supply tends to be inelastic and vice-versa.
Thus, several factors influence the elasticity of supply.
Q.4. Show how producers’ equilibrium is achieved with isoquants and isocost curves.
Answer.
PRODUCERS EQUILIBRIUM (Optimum factor combination or least cost combination).: The optimal combination of factor inputs may help in either minimizing cost for a given level of output or maximizing output with a given amount of investment expenditure. In order to explain producer’s equilibrium, we have to integrate Iso-quant curve with that of Iso-cost line. Iso-product curve represent different alternative possible combinations of two factor inputs with the help of which a given level of output can be produced. On the other hand, Iso-cost line shows the total outlay of the producer and the prices of factors of production.
The intention of the producer is to maximize his profits. Profits can be maximized when he is producing maximum output with minimum production cost. Hence, the producer selects the least cost combination of the factor inputs. Maximum output with minimum cost is possible only when he reaches the position of equilibrium. The position of equilibrium is indicated at the point where Iso-Quant curve is tangential to Iso-Cost line. The following diagram explains how the producer reaches the position of equilibrium.
It is quite clear from the diagram that the producer will reach the position of equilibrium at the point E where the Iso-quant curve IQ and Iso-cost line AB is tangent to each other. With a given total out lay of Rs. 5,000 the producer will be producing the highest output, i.e. 500 units by employing 25 units of factors X and 50 units of factor Y. (assuming Rs. 2,500 each is spent on X and Y)
The price of one unit of factor X is Rs.100-00 and that of Y is Rs. 50-00.. Rs.100 x 25 units of 2500 – 00 and Rs. 50 x 50 units of Y = 2500 – 00. He will not reach the position of equilibrium either at the point E1 and E2 because they are on a higher Iso-cost line. Similarly, he cannot move to the left side of E, because they are on a lower Iso-Cost line and he will not be able to produce 500 units of output by any combinations which lie to the left of E.
Thus, the point at which the Iso-Quant is tangent to the Iso-Cost line represents the minimum cost or optimum factor combination for producing a given level of output. At this point, MRTS between the two points is equal to the ratio between the prices of the inputs.
ISO-Quants and ISO-Costs
The prime concern of a firm is to workout the cheapest factor combinations to produce a given quantity of output. There are a large number of alternative combinations of factor inputs which can produce a given quantity of output for a given amount of investment. Hence, a producer has to select the most economical combination out of them. Iso-product curve is a technique developed in recent years to show the equilibrium of a producer with two variable factor inputs. It is a parallel concept to the indifference curve in the theory of consumption.
Meaning and Definitions
The term “Iso – Quant” has been derived from ‘Iso’ meaning equal and ‘Quant’ meaning quantity. Hence, Iso – Quant is also called Equal Product Curve or Product Indifference Curve or Constant Product Curve. An Iso – product curve represents all the possible combinations of two factor inputs which are capable of producing the same level of output. It may be defined as – “ a curve which shows the different combinations of the two inputs producing the same level of output .”
Each Iso – Quant curve represents only one particular level of output. If there are different Iso–Quant curves, they represent different levels of output. Any point on an Iso – Quant curve represents same level of output. Since each point indicates equal level of output, the producer becomes indifferent with respect to any one of the combinations.
Equal Product Combination
| Combinations | Factor X (Labor) | Factor Y Capital | Total Output in units |
| A | 12 | 1 | 100 |
| B | 8 | 2 | 100 |
| C | 5 | 3 | 100 |
| D | 3 | 4 | 100 |
| E | 2 | 5 | 100 |
In the above schedule, all the five factor combinations will produce the equal level of output, i.e.100 units. Hence, the producer is indifferent with respect to any one of the combinations mentioned above.
Graphic Representation
In the diagram, if we join points ABCDE (which represents different combinations of factor x and y) we get an Iso-quant curve IQ. This curve represents 100 units of output that may be produced by employing any one of the combinations of two factor inputs mentioned above. It is to be noted that an Iso-Product Curve shows the exact physical units of output that can be produced by alternative combinations of two factor inputs. Hence, absolute measurement of output is possible.
Iso – Quant Map
A catalogue of different combinations of inputs with different levels of output can be indicated in a graph which is called equal product map or Iso-quant map. In other words, a number of Iso Quants representing different amount of out put are known as Iso-quant map.
Marginal Rate of Technical Substitution (MRTS)
It may be defined as the rate at which a factor of production can be substituted for another at the margin without affecting any change in the quantity of output. For example, MRTS of X for Y is the number of units of factor Y that can be replaced by one unit of factor X quantity of output remaining the same.
| Combinations | Factor X | Factor Y | MRTS of x for y |
| A | 12 | 1 | Nil |
| B | 8 | 2 | 4:1 |
| C | 5 | 3 | 3:1 |
| D | 3 | 4 | 2:1 |
| E | 2 | 5 | 1:1 |
In the above example, we can notice that in the second combination the producer is substituting 4 units of X for 1 unit of Y. Hence, in this case MRTS of Y for X is 4:1.
Generally speaking, the MRTS will be diminishing. In the above table, we can observe that as the quantity of factor Y is increased relative to the quantity of X, the number of units of X that will be required to be replaced by one unit of factor Y will diminish, quantity of output remaining the same. This is known as the law of Diminishing Marginal Rate of Technical Substitution (DMRTS).
Properties of Iso- Quants:
1. An Iso-Quant curve slope downwards from left to right.
2. Generally an Iso-Quant curve is convex to the origin.
3. No two Iso-product curves intersect each other.
4. An Iso-product curve lying to the right represents higher output and vice-versa.
5. Always one Iso-Quant curve need not be parallel to other.
6. It will not touch either X or Y – axis.
ISO-Cost Line or Curve
It is a parallel concept to the budget or price line of the consumer. It indicates the different combinations of the two inputs which the firm can purchase at given prices with a given outlay. It shows two things (a) prices of two inputs (b) total outlay of the firm. Each Iso-cost line will show various combinations of two factors which can be purchased with a given amount of money at the given price of each input. We can draw the Iso-cost line on the basis of an imaginary example.
Let us suppose that a producer wants to spend Rs. 3,000 to purchase factor X and Y. If the price of X per unit Rs. 100 he can purchase 30 units of X. Similarly if the price of factor Y is Rs. 50 then he can purchase 60 units of Y.
When 30 units of factor X are represented on OY – axis and 60 units of factor Y are represented on OX- axis, we get two points A & B. If we join these two points A and B, then we get the Iso-Cost line AB. This line represents the different combinations of factor X and Y that can be purchased with Rs. 3,000.
The Iso-Cost line will shift to the right if the producer increase his outlay from Rs. 3,000 to Rs. 4,000. On the contrary, if his outlay decreases to
Rs. 2,000, there will be a backward shift in the position of Iso-cost line.
The slope of the Iso-cost line represents the ratio of the price of a unit of factor X to the price of a unit of factor Y. In case, the price of any one of them changes there would be a corresponding change in the slope and position of Iso-cost line.
PRODUCERS EQUILIBRIUM (Optimum factor combination or least cost combination).
The optimal combination of factor inputs may help in either minimizing cost for a given level of output or maximizing output with a given amount of investment expenditure. In order to explain producer’s equilibrium, we have to integrate Iso-quant curve with that of Iso-cost line. Iso-product curve represent different alternative possible combinations of two factor inputs with the help of which a given level of output can be produced. On the other hand, Iso-cost line shows the total outlay of the producer and the prices of factors of production.
The intention of the producer is to maximize his profits. Profits can be maximized when he is producing maximum output with minimum production cost. Hence, the producer selects the least cost combination of the factor inputs. Maximum output with minimum cost is possible only when he reaches the position of equilibrium. The position of equilibrium is indicated at the point where Iso-Quant curve is tangential to Iso-Cost line. The following diagram explains how the producer reaches the position of equilibrium.
It is quite clear from the diagram that the producer will reach the position of equilibrium at the point E where the Iso-quant curve IQ and Iso-cost line AB is tangent to each other. With a given total out lay of Rs. 5,000 the producer will be producing the highest output, i.e. 500 units by employing 25 units of factors X and 50 units of factor Y. (assuming Rs. 2,500 each is spent on X and Y)
The price of one unit of factor X is Rs.100-00 and that of Y is Rs. 50-00.. Rs.100 x 25 units of 2500 – 00 and Rs. 50 x 50 units of Y = 2500 – 00. He will not reach the position of equilibrium either at the point E1 and E2 because they are on a higher Iso-cost line. Similarly, he cannot move to the left side of E, because they are on a lower Iso-Cost line and he will not be able to produce 500 units of output by any combinations which lie to the left of E.
Thus, the point at which the Iso-Quant is tangent to the Iso-Cost line represents the minimum cost or optimum factor combination for producing a given level of output. At this point, MRTS between the two points is equal to the ratio between the prices of the inputs
Q.5. Discuss the full cost pricing and marginal cost pricing method. Explain how the two methods differ from each other.
Answer:.
Pricing Methods
The traditional theory of value and pricing policies etc., provide a theoretical base to the management to take decision on setting the right price. The actual pricing of products depend upon various factors and considerations. Hence there are several methods of pricing.
1. Full – Cost pricing or Cost Plus Pricing Method
Full cost pricing is one of the simplest and common methods of pricing adopted by different firms. Hall and Hitch of the Oxford University in their empirical study of actual business behavior found that business firms do not determine price and output by comparing MR and MC. On the other hand, under Oligopoly and monopolistic conditions they base their market price on full cost conditions. According to this principle, businessmen charge price that cover their average cost in which are included normal or conventional profits. Cost refers to full allocated costs. According to Joel Dean, it has three components –
i) Actual cost which refers to the actual or total expenses incurred in production. For e.g., wage bills, raw material cost, overhead charges etc.
ii) Expected cost refers to the forecast for the pricing period on the basis of expected prices, output rate and productivity.
iii) Standard cost refers to cost incurred at the normal level of output.
In brief, a firm computes the selling price of its product by adding certain percentage to the average total cost of the product. The percentage added to costs is called margin or mark-ups. Hence, this method is also called Margin – pricing and Mark – up pricing.
Cost +pricing = Cost + Fair profit
Fair profit means a fixed percentage of profit markups. It is arbitrarily determined. The margin of profits included in the price of a product differs from industry to industry and commodity to commodity on account of differences in competitive strength, cost of production, total turnover, accounting practices etc. Past traditions, directives from trade associations, guidelines from the government may also decide the percentage of profits.
This method envisages covering the total costs incurred in producing and selling a commodity In this case businessmen do not seek supernormal profit. Hence, a price based on full average cost is the ‘right cost’, the one which ought to be charged based on the idea of fairness under Oligopoly and Monopolistic competition.
Illustration
Production = 8000 units.
Total Fixed Cost = Rs 30,000
Total Variable Cost = Rs. 50,000
Total Cost = Rs. 80,000
Per Unit Cost = 80,000 / 8000 = Rs 10
20% Net Profit Margin
On Cost =
Cost Price = Rs 10
20% NPM on Cost = Rs. 10
Selling Price = + Rs. 2
Rs. 12
Marginal Cost Pricing
It is based on a pure economic concept of equilibrium of a firm, where marginal cost is equal to marginal revenue. Under this method price is determined on the basis of marginal cost which refers to the cost of producing additional units. Price based on marginal cost will be much more aggressive than the one based on total cost. A firm with large unused capacity will have to explore the possibility of producing and selling more. If the price is sufficient to cover the marginal cost, particularly in times of recession the firm should be able to produce and sell the commodity and can think of recovering the total cost in the long run.
This method though sounds excellent theoretically has the serious limitation of ascertaining the marginal cost.
Evaluation of the full cost pricing
Generally, the firms will not have information about demand conditions, nature and degree of competition, technology used etc., further modern business conditions are extremely uncertain. Besides a firm may be producing or selling innumerable varieties of goods and to calculate prices on the basis of profit maximization may be almost impossible. The cost plus method is convenient since the firms have only to add some standard mark-up to their cost. Over a period of time, through trial and error, they can find out the proper mark – up. The supreme merit of this method lies in its mechanical simplicity and its apparent fairness.
It is safer, cheaper and imparts competitive stability particularly when there is tough competition in the market. It is useful particularly in product tailoring and public utility pricing. It is justified on moral grounds because price based on costs is a just price.
According to Professor Joel Dean, it is the best method of pricing in case of new products because if the firm is able to realize its normal profits, then only it can take a decision to produce and market a product otherwise not.
This method attaches too much of significance to allotted costs and mark-ups. It tends to diminish the interest of the producer in cost control. However, many firms adopt this method of pricing due to its inherent benefits.
2. Rate of Return Pricing
Rate of return pricing is a modified form of full cost pricing. Under this method, a producer decides a predetermined target rate of return on capital invested. Full – cost pricing considers the mark-ups or profit arbitrarily. Instead of setting the percentage arbitrarily a firm will determine the average mark- up on costs necessary to produce a desired rate of return on the company’s investments. Thus, under this method, price is determined along a planned rate of return on investment. In this case, a company estimates future sales, future costs and arrive at a mark – up that will achieve a target return on a company’s investment.
Professor Davies and Hughes in their book, “Managerial Economics” have used the following formula to calculate the desired rate of return when a mark up is applied on cost.
Percentage mark – up =
Let us suppose that the capital employed by a firm is Rs.16 lacks and the total cost is Rs.12 lacks with a planned rate of return of 30 percent. By making use of the above formula, we can find out the percentage mark-up of the firm in the following way.
Illustration:
Production = 10,000 units
Total Cost = 4,00,000
Per Unit Cost = 4,00,000 / 10,000 = Rs 40
30% of Rs 40 is
Now, if the total cost per unit is = 40
30 % mark-up = 12
The selling price would be = 52
The mark-up is thus carefully planned and calculated, as different from the arbitrary percentage used in the cost plus pricing.
The management will regard this price as the base price applicable over a period of time. However, when cost of production changes as a result of changes in the prices of raw materials or due to changes in the levels of wages, the management can change the price suitably. Besides, the base price can be modified suitably according to changes in demand and competitive conditions in the market.
Q.6. Discuss the price output determination using profit maximization under perfect competition in the short run.
Answer: Price – Output determination under Perfect Competition (General Model)
It is very interesting to study the price – output model under perfect competition. Under a perfectly competitive market, in case of the industry, market price of the product is determined by the interaction of supply and demand. The market price is not fixed by either the buyer or the seller, firm, industry or the government. It is only the market forces, i.e., demand and supply determines the equilibrium price of the product. We come across this peculiar feature under perfect competition alone.
Alfred Marshall compared supply and demand to the two blades of a scissors. Just as both the blades work together to cut a piece of cloth, both supply and demand interact with each other to determine the market price at which exchange takes place. In the process of price determination, supply is not more important than demand or demand is not more important than supply. Both forces play an equally important role.
We can explain how price is determined in the market by the interaction of demand and supply with the help of the following schedule.
| Price in Rs. | Demand in Units | Supply in Units | State of Market | Pressure on price |
| 10 | 1000 | 9000 | Surplus S > D | Downward |
| 8 | 3000 | 7000 | Surplus S > D | Downward |
| 6 | 5000 | 5000 | Equilibrium S =D | Neutral |
| 4 | 7000 | 3000 | Shortage D > S | Upward |
| 2 | 9000 | 1000 | Shortage D > S | Upward |
From the table above, it is clear that equilibrium price is determined at Rs. 6.00 where quantity demanded is exactly equal to quantity supplied i.e., 5000 units.
Case of industry, interaction of supply and demand will determine the equilibrium market price. In the diagram, P indicates OR as equilibrium price and OQ as equilibrium output. The price at which demand and supply are equal is known as equilibrium price. The quantity bought and sold at the equilibrium price is known as equilibrium output.
In the figure equilibrium price is determined at the point P where both demand and supply are equal. The upper limit to the price of a product/service is determined by the demand. This price should not exceed ‘what the market can bear’. In short, the price of the product / service should not exceed the value of its benefit to the buyers (price should not be more than the utility of product / service).
The lower limit to the price is determined by production cost. In the long run, the price should not fall below production costs of making and distributing the product / service. With reference to the industry, the point P can be regarded as the position of stable equilibrium. Even if there are changes in price, there will be automatic adjustments in supply and demand, restoring the original equilibrium position. When the price rises from OR to OR1 supply exceeds demand, there will be excess supply over demand excess supply of goods push down the price from OR1 to OR, the original price.
Similarly, when price falls from OR to OR2, demand exceeds supply, excess demand over supply in its turn push up the prices from OR2 to OR – the original price. Thus, equality between demand and supply determine the market price.
Under perfect competition, a firm will not have any independence to fix the price of its own product. The industry is the price – maker or giver and a firm is a price – taker or price acceptor and quantity adjuster. As a part of the industry, it has to simply charge the price which is determined by the industry. If it charges a higher price it will loose its sales and if it charges lesser price, it will incur losses.
In case of the firm, the price line which is equal to AR and MR, will be horizontal and parallel to OX – axis. This is because same price has to be charged by the firm for all the units supplied, irrespective of changes in demand. Hence,
Price-Output Determination in the Short Period:
Short period is a time period in which there are two types of factors of production. One is the fixed factors and the other is the variable factors. In the short period, production can be changed only by changing the variable factors of production. Fixed factors of production cannot be changed. In other words, in the short period, supply can be changed only to some extent. In this period volume of production can be changed but capacity of the plant cannot be changed. He can increase the supply only with the help of existing machines and plants. New factories and plant-equipment cannot be installed.
The aim of a monopolist is to earn maximum profits or suffer minimum losses if the circumstances compel. Monopolist, being single seller of his product, can fix his price equal to, above or less than the short period average cost of the product. Thus, he can earn normal profits, supernormal profits or incur losses even in the short period.
This depends upon the nature and extent of the demand for his product. In order to earn maximum profits or suffer minimum losses, a monopolist compares his marginal revenue (MR) with marginal cost (MC). If marginal revenue exceeds marginal cost of a product, the monopolist can increase his profit by increasing his production. On the contrary, if MC exceeds MR at a particular level of output, the monopolist can minimize his losses by reducing his production. So the monopolist is said to be in equilibrium where marginal revenue is equal to marginal cost.
In the short period, a monopoly firm can earn supernormal profits, normal profits or incur losses. In case of losses, price must be covering at least the average variable costs. Otherwise the firm will stop production. The maximum loss can be equal to fixed costs. The three cases of monopoly equilibrium can be shown through the figures drawn below.
In figure (a) AR > AC. Hence, super normal profits.
In figure (b) AR = AC. Hence, normal profits.
In figure (c) AR < AC. Hence, losses.
The figures explain how a monopoly firm can earn supernormal profits, normal profits or incur losses in the short period.
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