LEARNING OUTCOMES UNIT - 2: DETERMINATION OF PRICES

After studying this unit, you would be able to:

• Explain how the prices are generally determined.

• Describe how changes in demand and supply affect prices and quantities demanded and supplied.

INTRODUCTION

• Prices of goods express their exchange value.

• Prices are also used for expressing the value of various services rendered by different factors of production such as
land, labour, capital, and organization in the form of rent, wages, interest, and profit respectively.

• Therefore, the concept of price, especially the process of price determination, is of vital importance in Economics.

• In this unit, we shall learn how demand and supply interact to strike a balance so that equilibrium price is determined in
a free market.

• A free market is one in which the forces of demand and supply are free to take their own course and there is no
intervention from outside by government or any other entity.

• It is to be noted that, generally, it is the interaction between demand and supplythat determines the price, but sometimes
Government intervenes and determines the price either fully or partially.

• For example, the Government of India fixes the price of petrol, diesel, kerosene, coal, fertilizers, etc. which are
critical inputs.

• It also fixes the procurement prices of wheat, rice, sugarcane, etc. in order to protect the interests of both producers
and consumers.

• While determining these prices, the Government takes into account factors like cost of inputs, risks of business,
nature of the product, etc.

PRICE DETERMINATION IN DIFFERENT MARKETS

• One of the main reasons for studying the demand and supply model is that the model is particularly useful in explaining
how markets work.

• A comprehensive knowledge of the movements of these market forces enables us to explain the observed changes in
equilibrium prices and quantities of all types of products and factors.

• We will be able to anticipate the possible market outcomes in real markets by applying the principles underlying the
interactions of demand and supply.

• Business firms can use the model of demand and supply to predict the probable effects of various economic as well
as non-economic factors on equilibrium prices and quantities.

• For example, the market outcomes of government intervention in the form of taxation, subsidies, price ceiling, and
floor prices, etc. can be analysed with the help of equilibrium analysis.
DETERMINATION OF PRICES - A GENERAL VIEW

• In an open competitive market, it is the interaction between demand and supplythat tends to determine equilibrium
price and quantity.

• In the context of market analysis, the term equilibrium refers to a state of market in which the quantity demanded of a
commodity equals the quantity supplied of the commodity.

• In an equilibrium state, the aggregate quantity that all firms wish to sell equals the total quantity that all buyers in the
market wish to buy and therefore, the market clears.

• Equilibrium price or market clearing price is the price at which the quantity demanded of a commodity equals the
quantity supplied of the commodity; i.e., at this price there is no unsold stock or no unsupplied demand.

To analyse how equilibrium price is determined in a market, we need to bring together demand for and supply of the
commodity in the market, for this we have the following schedule:

Table – 3: Determination of Price

S. No. Price (`) Demand Units Supply (Units)

1 1 60 5

2 2 35 35
3 3 20 45

4 4 15 55
5 5 10 65

• When we plot the above points on a single graph with price on Y-axis and quantity demanded and supplied on ** X-
axis, we get a figure as shown below:
• It is easy to see what will be the market price of the article.
• It cannot be 1, because at that price there would be 60 units in demand, but only 5 units on offer. Competition among
buyers would force the price up.
• On the other hand, it cannot be 5, for at that price, there would be 65 units on offer for sale but only 10 units in
demand. Competition among sellers would force the price down.
• At ` 2, demand and supply are equal (35 units) and the market price will tend to settle at this figure.
• This is equilibrium price and quantity – the point at which price and output will tend to stay.
• Once this point is reached, we will have stable equilibrium.
• Equilibrium is said to be stable if any disturbance to it is self-adjusting so that the original equilibrium is restored. In
other words, if the equilibrium be disrupted, the market returns to equilibrium. It should be noted that it would be stable only
if other things are equal.
• If the market price is above the equilibrium price, say ` 15, the market supply is greater than market demand and there
is an excess supply or surplus in the market. Competing sellers will lower prices in order to clear their unsold stock. As
we know, other things remaining constant, as price falls quantity demanded rises and quantity supplied falls. In this
process, the supply-demand gap is reduced and eventually eliminated thus restoring equilibrium.
• Likewise, if the prevailing market price is below equilibrium, say 5 in our example, a shortage arises as quantity
demanded exceeds the quantity supplied. The shortage prompts the price to rise, as the buyers, who are unable to obtain
as much of the good as they desire, bid the price higher. The market price tends to increase. Other things remaining the
 same, the price rise causes a decrease in the quantity demanded by the buyers and an increase in the quantity supplied by
the sellers and vice versa. This process will continue as long as demand exceeds supply. The market thus achieves a state
where the quantity that firms sell is equal to the quantity that the consumers desire to buy. At equilibrium price ( 10),
the supply decisions of the firms tend to match the demand decisions of the buyers. Thus, the equilibrium is restored
automatically, through the fundamental working of the market and price movements eliminate shortage or surplus.

Tabular Summary: Determination of Price

Concept Description
Equilibrium Price The price at which the quantity demanded equals the quantity supplied.

Excess Supply Occurs when the price is above equilibrium, leading to surplus goods.
Excess Demand Occurs when the price is below equilibrium, leading to shortage.

Stable Equilibrium When the market returns to equilibrium after a disturbance.

CHANGES IN DEMAND AND SUPPLY

• The above analysis of market equilibrium was done by us under the ceteris paribus assumption.
• The facts of the real world, however, are such that the determinants of demandother than price of the commodity under
consideration (like income, tastes and preferences, population, technology, prices of factors of production, etc.)
always change causing shifts in demand and supply.
• Such shifts affect equilibrium price and quantity.
• The four possible changes in demand and supply are:

1. An increase (shift to the right) in demand;

2. A decrease (shift to the left) in demand;

3. An increase (shift to the right) in supply;

4. A decrease (shift to the left) in supply.

• We will consider each of the above changes one by one.

An increase in demand:

• In figure 8, the original demand curve of a normal good is DD and supply curve is SS.
• At equilibrium price OP, demand and supply are equal to OQ.
• Now suppose the money income of the consumer increases and the demand curve shifts to D1D1 and the supply
curve remains the same.
• We will see that on the new demand curve D1D1 at OP price, demand increases to OQ2 while supply remains the
same i.e. OQ and there is excess demand in the market equal to QQ2.
• Since supply is short of demand, price will go up to OP1.
• With the higher price, supply will also shoot up generating an increase in the quantity supplied or an upward movement
along the supply curve.
• Ultimately, a new equilibrium between demand and supply will be reached.
• At this equilibrium point, ** OP1** is the price and OQ1 is the quantity which is demanded and supplied.
 • Thus, we see that, with an increase in demand, there is an increase in equilibrium price, as a result of which the
quantity supplied rises. As such, the quantity soldand purchased also increases.

Decrease in Demand:

• The opposite will happen when demand falls as a result of a fall in income, while the supply remains the same.
• The demand curve will shift to the left and become D1D1 while the supply curveremains as it is.
• With the new demand curve D1D1, at original price OP, OQ2 is demanded and OQis supplied.
• As the supply exceeds demand, price will come down and quantity demanded will go up.
• A new equilibrium price OP1 will be settled in the market where demand OQ1 will be equal to supply OQ1.
• Thus, with a decrease in demand, there is a decrease in the equilibrium price and quantity demanded and supplied.

Tabular Summary: Effect of Changes in Demand

Change in Demand Effect on Price Effect on Quantity Supplied

Increase Price rises Quantity rises

Decrease Price falls Quantity falls

Increase in Supply:

• Let us now assume that demand does not change, but there is an increase in supply say, because of improved
technology.

• The supply curve SS will shift to the right and become S1S1.

• At the original equilibrium price OP, OQ is demanded and OQ2 is supplied (with new supply curve).

• At the original price, a surplus now exists; as a result, the equilibrium price falls and the quantity demanded rises.

• A new equilibrium price OP1 will be settled in the market where demand OQ1 will be equal to supply OQ1.

• Thus, as a result of an increase in supply with demand remaining the same, the equilibrium price will go down and the
quantity demanded will go up.

Decrease in Supply:

• Let us now assume that due to obsolete technology, there is a decrease in supply.

• In figure 11, the supply curve SS will shift to the left and become S1S1.

• At the original equilibrium price OP, OQ is quantity demanded and OQ2 is quantity supplied (with new supply curve).

• At the original price, a deficit now exists; as a result, equilibrium price rises and the quantity demanded decreases.

• A new equilibrium price OP1 will be settled in the market where demand OQ1 will be equal to supply OQ1.

• Thus, as a result of decrease in supply, we will find that equilibrium price will go up, but the amount sold and
purchased will go down as shown in figure 11.
Tabular Summary: Effect of Changes in Supply

Change in Supply Effect on Price Effect on Quantity Demanded

Increase Price falls Quantity rises

Decrease Price rises Quantity falls

SIMULTANEOUS CHANGES IN DEMAND AND SUPPLY

• Till now, we were considering the effect of a change either in demand or in supplyon the equilibrium price and
quantity sold and purchased.

• It sometimes happens that events shift both the demand and supply curves at the same time.

• This is not unusual; in real life, supply curves and demand curves for many goods and services typically shift quite
often because of continuous change in economic environment.

• During a war, for example, shortage of goods will often lead to decrease in their supply while full employment causes high
total wage payments which increase demand.

What happens when the demand and supply curves shift in the same direction?

• We may discuss the effect on equilibrium price and quantity when both demandand supply increase simultaneously
with the help of the diagrams in the next page:

Simultaneous Change in Demand and Supply

• Fig. 12 shows simultaneous change in demand and supply and its effects on the equilibrium price.

• In the figure, the original demand curve DD and the supply curve SS meet at E at which OP is the equilibrium price
and OQ is the quantity bought and sold.

• Fig. 12(a) shows that increase in demand is equal to increase in supply.

• The new demand curve D1D1 and S1S1 meet at E1.

• The new equilibrium price is equal to the old equilibrium price (OP).

• However, equilibrium quantity is more.

• Fig. 12(b) shows that increase in demand is more than increase in supply.

• Hence, the new equilibrium price OP1 is higher than the old equilibrium price OP.

• The opposite will happen i.e. the equilibrium price will go down if there is a simultaneous fall in demand and supply and
the fall in demand is more than the fall in supply.

• Fig. 12(c) shows that supply increases in a greater proportion than demand.

• The new equilibrium price will be less than the original equilibrium price.
 • Conversely, if the fall in the supply is more than proportionate to the fall in the demand, the equilibrium price will go up.

What is the effect on equilibrium price and quantity when both demand and supply decrease?

• You can check it yourselves with the help of diagrams.

• We can summarise the two possible outcomes when the supply and demand curves shift in the same direction as
follows:

• When both demand and supply increase, the equilibrium quantity increases but the change in equilibrium
price is uncertain.

• When both demand and supply decrease, the equilibrium quantity decreases but the change in equilibrium
price is uncertain.

What happens when the demand and supply curves shift in opposite direction?

• We may discuss the effect on equilibrium price and quantity when demand and supply curves shift in opposite
direction with the help of the diagrams given in the next page:

Effect on Equilibrium Price and Quantity When Demand and Supply Curves Shift in Opposite Directions

• In panel (a) there is a simultaneous rightward shift of the demand curve and leftward shift of the supply curve.

• Here, the increase in demand is more than the decrease in supply, therefore, the equilibrium price and equilibrium
quantity will rise.

• In panel (b) there is also a coincident rightward shift of the demand curve and leftward shift of the supply curve.

• Here, the decrease in supply is more than the increase in demand, consequently, the equilibrium price rises and the
equilibrium quantity falls.

• In both cases, the equilibrium price rises from P to P1 as the equilibrium moves from E to E1.

What is the effect on quantity?

• In panel (a), the increase in demand is large relative to the decrease in supply and the equilibrium quantity rises as a
result.
• In panel (b), the decrease in supply is large relative to the increase in demand, and the equilibrium quantity falls as a
result.
• That is, when demand increases and supply decreases, the actual quantity bought and sold can go either way,
depending on how much the demand and supply curves have shifted.
 • In general, when supply and demand shift in opposite directions, we cannot predict what the ultimate effect will be on the
quantity bought and sold.
• What we can say is that a curve that shifts a disproportionately greater distance than the other curve will have a
disproportionately greater effect on the quantity bought and sold.
• We can summarise the two possible outcomes when the supply and demand curves shift in the opposite directions as
follows:

• When demand increases and supply decreases, the equilibrium price rises but nothing certain can be said
about the change in equilibrium quantity.

• When demand decreases and supply increases, the equilibrium price falls but nothing certain can be said
about the change in equilibrium quantity.

Tabular Summary: Simultaneous Changes in Demand and Supply

Change in Demand and Supply Effect on Price Effect on Quantity

Demand and Supply both increase Price uncertain Quantity increases

Demand increase > Supply increase Price rises Quantity increases

Supply increase > Demand increase Price falls Quantity increases

Demand and Supply both decrease Price uncertain Quantity decreases

Demand decrease > Supply decrease Price falls Quantity decreases

Supply decrease > Demand decrease Price rises Quantity decreases

ILLUSTRATION 1

• D1 and S1 are the original demand and supply curves.

• D2, D3, S2, and S3 are possible new demand and supply curves.

• Starting from initial equilibrium point (1), what point on the graph is most likely to result from each change given in
Questions 1 to 4?

SOLUTION

1. Assume X is a normal good. Holding everything else constant, assume that income rises and the price of a factor of
production also increases. What point in the figure above is most likely to be the new equilibrium price and quantity?

2. We are analyzing the market for good Z. The price of a complement good, good Y, declines. At the same time, there is
technological advance in the production of good Z. What point in the figure above is most likely to be the new
equilibrium price and quantity?

3. Heavy rains in Maharashtra during 2005 and 2006 caused havoc with the rice crop. What point in the figure
above is most likely to be the new equilibrium priceand quantity?

4. Assume that consumers expect the prices of new cars to significantly increase next year. What point in the figure above
is most likely to be the new equilibrium price and quantity?
Let us try answering these questions.

1. When income of people rises, the demand curve will shift to right (becomes D2) as X is given to be a normal good. An
increase in the price of factors of productionused in the production of the good under consideration will decrease its
supplyand shift the supply curve to the left to S3. The new demand and supply of X will meet at Point 2.

2. When the price of a complementary good falls, the demand for the good in question increases. Therefore, when the
price of the complementary good Y falls, the demand curve for Z will move to right and become D2 and due to
technological advancement the supply of Z will increase and become S2. The new demand and supply of Z will
meet at Point 7.

3. Due to heavy rains, the supply of rice will fall and the new equilibrium point will be 3. It is assumed that there is no
change in demand.

4. If prices of cars are expected to increase in future, the demand curve will shift to right. Assuming that the supply
remains constant, the new equilibrium point will be 5.

Tabular Summary: Illustrative Changes

Scenario Change in Demand Change in Supply New Equilibrium Effect

Income rises Demand shifts right No change Price rises, quantity increases
Price of complementary good falls Demand shifts right No change Price rises, quantity increases

Supply shock (e.g., natural disaster) No change Supply shifts left Price rises, quantity decreases
Price expectations increase Demand shifts right No change Price rises, quantity