BBA I Semester Managerial Economics Pricing Under Perfect Competition Study Material Notes

BBA I Semester Managerial Economics Pricing Under Perfect Competition Study Material Notes: Perfectly Competitive Market Equilibrium Table 1 Changes in Demand and Supply Effects of Combined Changes in Demand and Supply Market Period Price Importance of time Element in Price Theory Short Period Price Long Period Price or Normal price Conclusion Secular Period Exercise Questions  :

MCom I Semester Corporate Accounting Valuation Shares study Material Notes

PRICING UNDER PERFECT COMPETITION

PERFECTLY COMPETITIVE MARKET EQUILIBRIUM

A perfectly competitive market is one in which the number of buyers and sellers is very large, all engaged in buying and selling a homogeneous product without any artificial restrictions and possessing perfect knowledge of market at a time.

There are two parties that bargain in such a market, the buyers and the sellers. It is only when they agree, a commodity can be bought and sold at a certain price. Thus product pricing is influenced both by buyers and sellers, that is by demand and supply.

The law of demand is applicable to buyers. According to this, when price rises, demand falls and vice versa. The law of supply applies on the supply side. This law states that supply increases with the rise in price, and decreases with the fall in price. Thus demand and supply are the two counteracting forces which move in the opposite directions. Price is determined at a point where these two forces are equal, and that is known as the equilibrium price. Quantity demanded and supplied at this price is called the equilibrium quantity. When price is less or more than the equilibrium price, there is disturbance in the equilibrium output. But ultimately equilibrium price will prevail. This pricing process is explained in terms of Table 1 and Figure 1

Pricing Under Perfect Competition

TABLE 1

The demand and supply schedule of apples is shown in the above Table. When the price of apples is Rs. 10 per kg., 120 kg. of apples are demanded and 20 kg. are supplied. With the rise in price, demand is falling and supply is increasing. When the price of apples is Rs. 40 per kg., both demand and supply are 60 kg. This is the equilibrium quantity which has been determined by the equilibrium price of Rs. 40. Once the equilibrium price is established, there is no tendency for it to change. If at any time, price becomes lower or higher than Rs. 40. For instance, if the price falls 40 to Rs. 30, the demand rises to 80 kg. and the supply decreases to 45 kg. Less supply of apples in relation to higher demand for them will raise the price to Rs. 40. As a result, the demand will fall to 60 kg, and the supply will also increase to 60 kg. Thus the equilibrium price is re-established.

On the contrary, with the price rises to Rs. 50, demand falls to 40 kg. and supply increases to 80 kg. When every seller tries to sell his product (apples) first, he has to lower his price a little and others also follow him till the price comes down to Rs. 40 and the equilibrium between demand and supply is re-established. equilibrium price and (Rs. 50) P, output are shown. DD, is the demand curve and SS, is the supply curve. (Rs. 40) P Both intersect at E which is the equilibrium point. OP is the (Rs. 30) P. equilibrium price at which og equilibrium quantity is bought and Demand sold. If the price falls from OP to OP demand P, d,>P, s, supply and represents the excess demand. Since Quantity demand is greater than supply, competition among buyers will raise the price from OP, to the equilibrium price OP. If the price rises from OP to OP, supply P,s>P, d demand which leads to an excess supply of ds quantity in the market. Since demand is less than supply, every seller will try to sell his quantity of the product first by lowering the price a little. Ultimately, competition among sellers will bring down the price to the equilibrium level. Thus price is determined by demand and supply and once the equilibrium price is established, any deviation from this level will be restored by the automatic forces of demand and supply.

Pricing Under Perfect Competition

Changes in Demand and Supply

We studied static equilibrium in the above analysis by assuming unchanged demand and supply. But in reality, changes in demand or supply, or in both bring about changes in equilibrium price and quantity, and at every change a new 8 equilibrium position is established. The effects of changes in demand and supply on the price and quantity of a product are explained with the help of figures.

Effects of Changes in Demand. Changes in demand are due to changes in tastes, income and preferences of consumers, etc. The effects of changes Quantity in demand are shown in Figure 2 where D and S are the demand and supply curves respectively which intersect at E and establish O equilibrium quantity at OP equilibrium price. Given the supply if the demand rises, the demand curve shifts upward as D, which intersects the supply curve Sat E. The equilibrium price rises form OP to OP, and the equilibrium quantity from 0 to 0Q,. On the contrary, with the fall in demand the demand curve D shifts downward as D, and intersects the supply curve Sat E. As a result, the price falls from OP to OP, and quantity from OQ to OQ. Thus, given the supply, rise in the demand of the product raises both the price and the quantity, and vice versa. If the supply curve is elastic, a change in demand brings about a smaller change  price and a larger change in quantity. In Figure 3 (A), S is an elastic curve. With the upward or downward shift in Dto D, or D, the change in price from OP to OP, or OP, is less than the change in quantity from Q to 09, or 0Qz. On the contrary,

if the supply curve is less elastic a change in demand leads to a larger change in

price and a smaller change in quantity. Such a situtation is shown in Figure 3 (B) where S is the less elastic supply curve with the change in demand from Dto D or D,, the change in price from OP to OP, or OP, is greater than the change in quantity from 0 to 0g, or OQ.

Effects of Changes in Supply. Changes in supply are due to changes in technical knowledge and factor prices. Figure 4 shows the effect of changes in supply. Given the demand, when the supply increases, the supply curve shifts downward, to the right. As a result the price of the product falls and its quantity increases. Taking S and D as the supply and demand curves respectively, they intersect at E and establish OP price and OQ quantity. Given the demand,

when the supply increases, the supply curve S shifts downward as S, and new equilibrium is established at E As a result, the other hand, with the decrease in supply, the supply curve S shifts upward as S. The new equilibrium is established at E). The price rises from OP to OP, and the quantity decreases from OQ to og

If the demand curve is less elastic as shown in Figure 5 (A), with the change in supply, the change in quantity is less than the change in price. The change in quantity from OQ to 09, or 09, is less than the change in price from OP to OP, or OP. On the other hand, when the demand curve is elastic, the change in quantity is more than the change in price. Figure 5 (B) shows that the change in quantity from 0 to 0Q, or OQ, is more than the change in price from OP to OP, or OP.

Effects of Combined Changes in Demand and Supply

Now we analyse the effects of combined increase or/and decrease in demand and supply.

Combined Increase in Demand and Supply. When there is a combined increase in demand and supply, there is a definite increase in the quantity of the product but the rise or fall in price is not certain. Price rises only when the increase in demand is more than the increase in supply. This is shown in Figure 6 (A) where OP and OQ are the equilibrium price and quantity respectively. If there is a combined increase in demand and supply, but the increase in demand (D) is more than the increase in supply (S), the price rises from OP to OP, and the quantity also increases from OQ to 0 .

On the other hand, if the increase in supply is more than that in demand, the price falls. In Figure 6 (B), the increase in supply from

to S, is greater than the rise in demand from D to D. As a result, the new equilibrium point is E. The new price OP, is less than the old price OP but the quantity of the product has increased from OQ to 0,

When the increase in demand and supply is uniform, there is no change in price. This is shown in Figure 6

(C). Where the increase in supply by SS, is exactly equal to the increase in demand by DD. The new price E,, equals the old price OP (EQ), but the quantity has increased from 0 to 0 .

Pricing Under Perfect Competition

Combined Decrease in Demand and Supply. When there is a combined decrease in demand and supply, there will be a fall in the quantity of the product. But the change in price will depend upon the relative decline in demand and supply. Taking D, as the original demand curve and S, as the original supply curve, and the corresponding new demand and supply curves as D and S respectively, the combined decrease in demand and supply can also be explained with the help of Figure 6 (A),(B), and (C). In Figure 6 (A), the decrease in demand (from D, to D) is more than that in supply (from S, to S). As a result, price falls from OP, to OP. In Figure 6 (B), the decrease in supply is more than that in demand. Consequently, price rises from OP, to OP. In Figure 6 (C), the decrease in demand being equal to the decrease in supply, there is no change in price, EQ=OP (=E,2,).

Combined Increase in Demand and Decrease in Supply. The combined effects of increase in demand and decrease in supply are depicted in Figure 7 (A), (B), and (C). The increase is demand is shown by D, curve and decrease in supply by S, curve. In Figure 7 (A), when the increase in demand (from D to D) is greater than the decrease in supply (from Sto S), the price rises from OP to OP, and the quantity increases from OQ to OQ, Figure 7 (B) shows a greater decrease in supply than the increase in demand. The price rises from OP to OP, but the quantity decreases from OQ to og, because supply is larger than demand. Figure 7 (C) depicts the case of a uniform increase in demand and decrease in supply (DD, ESS). Consequently, the price rises from OP to OP, but there is no change in quantity 0Q

The combined effects of decrease in demand and increase in supply can be explained in terms of Figure 7 (A), (B), and (C) by taking D, and S, as the original demand and supply curves respectively.

Conclusion. The above analyses reveals that price is determined by the combined forces of demand and supply. As pointed out by Stonier and Hague, “The only really accurate answer to the question whether it is supply or demand which determines price is that it is both. At times it will seem that one is more important than the other, for one will be active and the other passive. For example, if demand remains constant but supply conditions vary, it is demand which is passive and supply acti than the other in determining price.” But demand price determination. They are simply formulas. The real forces which influence demand and supply. For instance, the demand to which is passive and supply active. But neither is more or less important ermining price.” But demand and supply are not the real factors for i ney are simply formulas. The real factors of price determination are the supply. For instance, the demand for a commodity he incomes, tastes, preferences, habits, and fashions of consumers, on the and growth of population and on the prices of related goods. A change in any one or more of these factors influences the demand for goods which, in turn, influences their y, the supply of a commodity depends on the technique of production and on the prices of different factors which influence the cost of production. As a result, supply

in turn, influences the price of a product. Professor Samuelson has explained the importance of the various factors that lie behind demand and supply in price determination thus: “Supply and demand are not ultimate explanations of price. They are simply useful catch-all categories for analysing and describing the multitude of forces, causes, factors impinging on price. Rather than being the final answers, supply and demand simply represent initial questions. Our work is not over but just begun.”

Pricing Under Perfect Competition

IMPORTANCE OF TIME ELEMENT IN PRICE THEORY

Marshall was the first economist who analysed the importance of time element in price determination. When the demand for a product rises or falls, its supply does not increase or decrease at the same time. Changes in supply depend on technical factors which take time to change. Therefore, the adjustment between demand and supply does not take place at once. The period involved in adjustment will depend on the extent to which it is possible to make changes in the scale of production, size and organisation of the industry in accordance with the changing demand for its product. The importance of the time element in pricing also underlies the nature of the products. The pricing of perishable foods has more importance in the very short period while that of durable goods in the long period. Marshall has divided the pricing of products into four time periods: market period, short period, long period, and secular period. We analyze these time periods one by one.

Pricing Under Perfect Competition

Market Period Price

The market period is a very short period in which supply being fixed, price is determined by demand. The time period is of a few days or weeks in which the supply of a commodity can be increased out of a given stock to match the demand. This is possible for durable goods. The time period for perishable commodities is only a day. For instance, if the demand for a vegetable increases, its supply cannot be increased on the same day. Therefore, the supply of vegetable being fixed, its price is determined by demand on that day.

The price prevailing in the market is called the market price which changes with the nature of the commodity many times within a day or a week or a month. Marshall explained the market price thus: “The market value… is often influenced by passing events and causes whose action is fitful and short-lived than by those which work persistently.” ‘ In reality. market price is that price which is determined by the forces of demand and sunnly in market at a point of time. The determination of market price is explained separately for perishable and durable commodities.

Perishable Commodities. The price of a perishable commodity like milk, vegetables. fish, etc. is primarily influenced by its demand. Supply has no influence on price because it! is fixed. Therefore, the price of a perishable commodity rises with the increase in its demand, and falls with the decrease in its demand. Figure 8 depicts the price determination of a perishable commodity, fish. MS is the market supply curve which reflects the fixed quantity og of fish in the market period. D is the initial demand curve which intersects the supply curve MS at E, and the market price OP is determined. If the demand for fish rises from D to D, the new equilibrium is established at E, and the price increases to OP. On the other hand, with the fall in demand from Dto D, price also falls from OP to OP.

Thus the market price is determined by demand alone while the supply (OQ is fixed. We also find in reality that the prices of perishable commodities like vegetables, milk, fish, etc. rise or fall many times a day in summer with the rise or fall in the demand for them.

Durable Commodities. Most commodities are durable which can be kept in stock. When the price of a durable commodity increases with the increase in its demand, its supply can be increased out of the given stock. Such commodities are cloth, wheat, tea, etc. They have two price levels. First, a minimum price below which a seller will not sell his commodity. This is also known as the reserve price. Second, a minimum price at which the seller will be prepared to sell the entire quantity of his commodity.

While fixing the reserve price for his commodity, any seller would take into consideration the following factors:

(i) Durability of the Commodity. The reserve price depends on the durability of the commodity. The more durable a commodity is, the higher will be its reserve price.

(ii) Prices in Future. The reserve price depends on future changes in price. If the seller expects prices to increase in future, he will fix a high reserve price, and vice versa.

(iii) Future Cost of Production. The reserve price also depends on the future cost of production of the commodity. If the sellers expect cost to rise in future, they will fix a high reserve price, and vice versa.

(iv) Expenses on Storage. The reserve price also depends on the time and expense involved in the storage of the commodity. The greater the time and expense in storing the commodity, the lower will be the reserve price because the seller would like to dispose off his commodity at the earliest so as to avoid the expenses of storage, and vice versa.

(v) Liquidity Pereference. The reserve price depends on the liquidity preference of the sellers. The higher the liquidity preference, the lower will be the reserve because the seller would try to sell his commodity at the earliest in order to have cash in hand. On the contrary, if the liquidity preference is low the reserve price will be high.

(vi) Demand in Future. The reserve price also depends on the future demand. If the seller expects the demand to rise in future, he will fix a high reserve price, and vice versa.

Thus there being two price levels, the seller will not sell any quantity of his commodity at the reserve price, whereas he would be prepared to sell the entire quantity at the maximum

price. As the price of the commodity increases with the rise in its demand, the seller will continue to sell larger quantity of his commodity till the demand rises to the level of the maximum price where he will dispose off his entire stock of the product. After this, it is not possible to increase the supply to match any increase in demand. This also explains the vertical shape of the supply curve for a durable commodity.

SMS, is the supply curve during the market period in Figure 9. OQ, is the total supply of the commodity. OS is the minimum or reserve price at which the seller does not sell his commodity.

Quantity When the demand curve D intersects the supply SMS, at E, OP price is determined at which he sells o quantity of his commodity and keeps 00, in stock. If the demand is D, the prices IS OP’, at which he sells OQ, quantity and keeps 0.0, in stock. It is only when the demand increases to D, that the seller would be prepared to sell the entire stock of his commodity at the maximum price of OP,. If the demand rises beyond D, it will only raise the price above OP, because in the market period not more than oQ, quantity can be sold.

Thus in the market period demand has a greater influence than supply in price determination because the seller does not consider production costs.

Short Period Price

The short period relates to a few months in which supply can be changed in accordance with demand. This is possible by changing the variable factors. For instance, if the firm wants to increase the supply of its product it can do so by working the fixed factors like existing plants, machines, etc. more fully. This can be done by starting two or three shifts and by employing more labour, raw materials, etc. In the short period, it is not possible to change the fixed factors, the scale of production and organisation. Therefore, supply can be increased or decreased to match the increase or decrease in demand by changing the variable factors.

In the short period, price is determined by the forces of demand and supply. The shortrun supply curve slopes upward from left to right like the ordinary supply curve. It establishes the MS short-run equilibrium price when it is intersected by the demand curve. The short-run price is also known as the short-run normal price. Its determination is shown in Figure. 10. D is the original demand curve and MS is the market period supply curve. Both intersect at P and establish PQ price and OQ quantity. Suppose the demand for cloth rises which is reflected in the D, curve. The immediate effect will be for the market price to increase from PQ to P’Q. Since supply is fixed in the market period, it is not possible to increase it beyond OQ. But it is possible to increase it with the help of existing plants and machines by employing extra labour and raw materials, etc. Thus by increasing the variable factors, the supply will be increased along the SRS curve. The SRS curve intersects the new demand curve D, at P. In this way, the short-run normal price P, Q, is determined at which oQ, the quantity of the commodity is bought and sold. This! short-run price P, Q, is higher than the original market price PO but is lower than the market price P’Q which prevailed after the increased demand.

Now suppose that the demand for cloth falls. The demand curve shifts from Dto D. The market price immediately falls from PQ to P”Q. 8 All the firms in the industry will try to reduce the a supply by reducing the amount of variable factors like labour and raw materials, etc. As a result, the new equilibrium is established at P, where the curves SRS and D, intersect. Now OQ, quantity is bought and sold at PQ, price. This short-run price is less than the original market o q , a Q, price PQ but is higher than the price PQ Quantity established after the fall in demand. Thus supply is more important than demand in the short period because supply can be increased or decreased to match the rise or fall in demand by changing the variable factors.

Long Period Price or Normal Price

The long period is of many years in which supply can be fully adjusted to demand. This is done by changing the fixed factors. During this period, the old machines, equipments and plants can be replaced by the new. New firms can enter the industry and old firms can leave it. The scale of production, organisation and management can also be changed. Thus supply can be adjusted to demand in every possible way in the long-run.

Long period price is also known as the normal price. Normal price is that price which is likely to prevail in the long-run. In the words of Marshall: “Normal or natural value is that which economic forces would tend to bring about in the long-run.” Long period or normal price is determined by the equilibrium of demand and supply. For the equilibrium of firms and industry in the long-run, it is essential that normal price should equal the long-run marginal cost and average cost. If the price is above the minimum long-run average cost, all the firms would be earning super-normal profits. These extra profits would attract new firms into the industry. As a result, supply would increase and price would come down to the level of the minimum long-run average cost. On the contrary, if the price falls below the minimum longrun average cost, firms would incur losses. Some of the firms that cannot sustain losses would leave the industry, supply would be reduced and price would rise to the level of the minimum long-run average cost. Thus the long period or normal price is always equal to the minimum long-run average cost. This is depicted in Figure 11 where LAC and LMC are the long-run average and marginal cost curves respectively. The long-run equilibrium point is E, where LMC=MR=AR=LAC at its minimum point. It sets OP price at which o quantity of the commodity is sold. This is the normal price which has the tendency to prevail in the longrun If the price increases from OP to OP, the firms would sell 20, additional quantity and earn AB extra profits per unit of the commodity. The extra profits would attract new firms into industry, the supply would increase further and ultimately bring down the price to the OP! level where the long-run equilibrium would be re-established at point E. On the contra with the fall in price from OP to OP ,, the firm from OP to OP, the firms would reduce the supply to 00, and thereby incur CD losses per unit of the commodity. Unable to sustain these losses, some would leave the industry. Consequently, the supp start rising and ultimately reach the OP level where the Consequently, the supply would decrease further, price would reach the OP level where the long-run equilibrium would be reestablished at point E.

Pricing Under Perfect Competition

Secular Period

har period is very long. According to Marshall, it is a period of more than ten years in which changes in demand fully adjust them

changes in demand fully adjust themselves to supply. Since it is not possible to estimate the changes in demand due to changes in techniques of production, population

5, etc. over a very long period, Marshall did not analyse pricing under the secular period.

Conclusion

The above analysis shows the importance of time element in price theory. It points out that of the two forces, demand and supply, which force is more important in the price determination depends on the time period. Generally, the shorter the time period, the greater will be the influence of demand on pricing and the longer the time period, the greater will be the influence of supply on the determination of prices of commodities.

Comparison Between Market Price and Normal Price

We now attempt a comparison between market price and normal price.

(1) Market price is that price which prevails in a market on a single day or on very few days. It is a very short-period price which prevails at a particular time. On the other hand, normal price is that price which tends to prevail in the long-run. It is a price which has a tendency to prevail over a period of time.

(2) In the determination of market price, demand plays an active role while supply is passive. The market price rises or falls with the rise of fall in demand while supply is fixed. On the other hand, supply is more active in the determination of normal price because it tends to adjust itself fully to any change in demand.

(3) Market price is influenced by temporary events. It may change many times a day or a week as a result of passing events. A sudden rainfall on a hot day may bring down the demand for ice, and hence lower its price. Thus market price exists only temporarily and its equilibrium is also temporary. Normal price, on the other hand, is the outcome of permanent forces which bring about changes in demand and supply. Demand may change due to astes, habits, preferences, etc. of consumers, while supply may change by altering the fixed factors of production. Normal price is thus a perma-nent and stable price permanent equilibrium.

Market price, therefore, tends to show oscillations around normal price, as shown in where NP denotes normal and MP market price. Market price can be above or below the average cost of production. Hence firms normal profits or incur losses. On the other hand, normal price is always equal to the long-run average cost (LAC) at its minimum point. Therefore, firms can earn only normal profits under normal price.

(5) All commodities whether reproducible or non-reproducible have market price. But only reproducible commodities have normal price. If a commodity is non-reproducible, its supply cannot be increased in the long-run when its demand increases. For instance, a painting done by Tagore lying with a curios dealer cannot have normal price because Tagore is no longer alive to repaint the like of it. It can only be sold at the market price which it fetches at a particular time.

(6) Market price is the real price which prevails in the market at any time. On the other hand, normal price is a hypothetical price. It is an abstraction, a myth. Something unreal and imaginary. It is like a mirage. The small waves in the sea are real but the calm water of the sea in the distant horizon is like a mirage. The small waves represent the market price while the calm water in the distant, the normal price. The price that rules in the market is always the market price and not the normal price.

(7) Firms can either earn abnormal profit or incur loss under market price, whereas they can earn only normal profit under normal price.

(8) Under market price, there is the temporary equilibrium of demand and supply, while there is permanent equilibrium under normal price.

Pricing Under Perfect Competition

EXERCISES

1 Explain with the help of a diagram how price is determined in a perfectly competitive market.

2. Explain Marshall’s three-period analysis on the pricing of products in a competitive market. Illustrate with the help of diagrams.

3. Discuss the importance of time-element in the theory of value.

4. Define ‘normal price’. Why must the long period normal price be always equal to the minimum average costs in the industry?

5. Distinguish between market price and normal price. How is the normal price determined?

Pricing Under Perfect Competition