eco ch 12 starting final

PRICE DETERMINITION 2.1

CHAPTER 12Price Determination

Market Equilibrium under perfect competition and effect of shift in Demand and Supply.

Market Equilibrium:Market Equilibrium is a situation of the market in which demand for a commodity is exactly equal to its supply corresponding to a particular price.

a) Equilibrium Price:Equilibrium Price which corresponds to the quality between the market demand and market supply of a commodity.

b) Equilibrium quantity:Equilibrium quantity which corresponds to the price in the market.

Determination of Market Equilibrium under:Perfect Competition:In perfect competition firm is price taker and price are determined by industry with the help of market forcer of demand and supply.

Equilibrium refers to state of balance under perfect competition market equilibrium is determined when market demand is equal to market supply.

Here Market Demand is the sum of total of demand for a commodity by all the buyers in the market. Its curve slope downwards due to Law of Demand.

VINAY GUPTAM.B.A., M. Com., PGDCA, B.Ed., STET Qualified Ph. 9896254005

PRICE DETERMINITION Page 12.2

Market Supply is the total of supplies of a commodity by all the producers in the market. Its curve slopes upward due to operation of law of supply.Market Equilibrium under Perfect competition:

Price of Chocolate

(Rs)

Market Demand

of Chocolate

Market Supply of Chocolate

Storage(-) OR

Supply (+)

Remarks

2 100 20 (-)80 Excess Demand

4 80 40 (-)40 MD > MS

6 60 60 0Equilibrium

Level,MD = MS

8 40 80 (+)40 Excess Supply

10 20 100 (+)80 MS > MD

1) Market Equilibrium is determined at point E when MD = MS.

2) Equilibrium Price = Rs 6.3) Equilibrium Quantity = 60 units.

Three Basic Assumption of (Price Determination) Market Equilibrium under Perfect Competition:

1. Price & Quantity supplied are positively related.2. Price & Quantity demanded are negatively related.3. Forcer of supply & Demand operate freely without any

government intervention.

Excess Demand OR When Market Price < Equilibrium Price:Excess Demand refer to a situation when quantity Demanded > Quantity Supplied at prevailing market Price. Here market Price is less than equilibrium price.

In the given Diag & Previous table:



When price is < equilibrium price then:1. There shall be excess demand D > S.2. Here consumers want more quantity but supply is less.

Leads to increase in price.3. With increase in price quantity demanded will fall due to

law of Demand & Quantity supplied will rise due to law of supply.

4. This process will continue till the equilibrium price will set again & excess demand will wiped out.

Thus price will increase to a level where market Demand = Market Supply.

Excess supply OR When Market Price > Equilibrium Price:Excess Supply refers to a situation when prevailing market price. Here market price is more than equilibrium price.

In the given diag. & previous table when price > Equilibrium Price

1. There will be excess supply S>D.2. Due to this excess supply there will be

reduction in market price.3. In response to a reduction in price

quantity supplied will start decreasing this triggers downward moment along the supply curve & Quantity demanded will increase their triggers right ward movement along the same demand curve

4. This process will continue till the equilibrium price will set again & excess supply will wiped out. Thus price will decrease to level where Market Demand = Market Supply various cases of change (shift) in Demand & Supply on Equilibrium price



Here in both situation number of firms are fixed or supply is fixed or no change in supply


Change In DemandChange In SupplyDemand ↓ Supply ↑Special Cases


CHANGE IN DEMAND: (Assuming No Change in supply)i. INCREASE IN DEMAND: Numbers of firms are fixed Or

supply is fixed.

Chain of effect:

1. Due to ↑ increase in Demand- Demand curve will shift from DD to D1D1 to right side

2. Due to that there will be excess Demand = EF

3. It leads to ↑ in price.4. Rise in price inducer extension of supply & contraction in

Demand.5. This process will follow till the new equilibrium with point

E1 will setHere (i) new will Equilibrium Price= OP1

(ii) New Equilibrium Quality =OQ1

Decrease in Demand:

Chain of Effect

1. Due to decrease in Demand, Demand curve will shift to left side from DD to D1D1.

2. Due to this there will be excess supply = EF.

3. It leads to ↓ in price.4. Decrease in price inducer contraction

in supply & extension of Demand5. This process will follow till the new equilibrium point E1 will

set. Here – (i) New Equilibrium Price = OP1 (ii) New Equilibrium =OQ1



CHAIN IN SUPPLY: (Assuming no change in Demand)(i) Increase in Supply

Chain of Effect:

1. Due to ↑ in Supply, supply curve will shift from SS to S1S1 to right side.

2. Due to their will be excess supply = EF.3. It leads to ↓ in price.4. ↓ in price inducer extension of demand

& contraction of supply.5. This process will continue till the new equilibrium point E1

will set here (i) New equilibrium price will fall to OP1

(ii) New equilibrium quantity will rise to OQ1

(ii) Decreasing Supply:

Chain of Effect:

1. Due to decrease in supply, supply curve will shift to left side from SS to S1S1.

2. Due to this there will be excess Demand = EF.

3. It leads to ↑ in price.4. ↑ in price inducer extension of supply & contraction of

Demand.5. This process will continue till new equilibrium Point E1 will

set.Here (i) New equilibrium Price will raise to OP1

(ii) New equilibrium quantity will fall to OQ1

I. When both Demand & Supply Decreases:

Case 1: Decrease in Demand = Decrease in Supply

When decrease in demand is proportionately equal to decrease in supply, then leftward shift in demand curve from DD to D1D1

is proportionately equal to leftward shift in supply curve from



SS toS1S1 (Fig.). The new equilibrium is determined at E1. As demand and supply decrease in the same proportion, equilibrium price remains same at OP, but equilibrium quantity falls from OQ to OQ1.

Case 2: Decrease in Demand > Decrease in Supply

When decrease in demand is proportionately more than decrease in supply, then leftward shift in demand curve from DD to D1D1 is proportionately more than leftward shift in supply curve born SS to S1S1 (Fig.). The new equilibrium is determined at E1, equilibrium falls from OP to OP1 and equilibrium quantity falls from OQ to OQ1.

Case 3: Decrease in Demand < Decrease in Supply



When decrease in demand is proportionately less than decrease in supply, then ad shift in demand curve from DD to is proportionately less than leftward shift in supply curve from SS to S1S1 (Fig.). The new equilibrium is determined at E1, equilibrium price rises from OP to OP1 whereas, and equilibrium quantity fails from OQ to OQ1.

(ii) Both Demand and Supply Increase

Original Equilibrium is determined at point E, when the original demand curve DD and the original supply curve SS intersect each other, OQ is the equilibrium quantity and OP is the equilibrium price. The effect of increase in both demand and. supply on equilibrium price and equilibrium quantity is discussed under three different cases:Case 1: Increase in Demand = Increase in Supply

When increase in demand is proportionately equal to Increase in supply, then rightward shift in demand curve from DO to DD Is proportionately equal to rightward shift in supply curve from SS to S1S1 (Fig.). The new equilibrium is determined at E. As both demand and supply increase in the same proportion, equilibrium price remains the same at OP, but equilibrium quantity rises from QQ to OQ1.



Case 2: Increase in Demand > Increase in Supply

When increase in demand is proportionately more than increase in supply, then rightward shift in demand curve from DD to D1D1 is proportionately more than rightward shift in supply curve from SS to S1S1 (Fig.). The new equilibrium is determined at E equilibrium price rises from OP to OP1 and equilibrium quantity rises from QQ to OQ1



Case 3 Increase In Demand < Increase in Supply

When increase in demand is proportionately less than increase in supply, then rightward shift in demand curve from DD to D1D1 is proportionately less than rightward shift in supply curve from SS to S1S1 (Fig.). The new equilibrium is determined at E, equilibrium price falls front OP to OP whereas, equilibrium quantity rises from QQ to OQ1.

(iii) Demand decreases and Supply Increases

The effect of simultaneous decrease in demand and increase in supply on equilibrium price and equilibrium quantity is analyzed in the following three cases:Case 1: Decrease in Demand = Increase in Supply

When decrease in demand is proportionately equal to increase In supply, then leftward shift in demand curve from DD to D1D1

is proportionately equal to rightward shift in supply curve from 55 to SS (Fig.), The new equilibrium is determined at E. equilibrium quantity remains the same at OQ, but equilibrium price falls from OP to OP1.



Case: 2. Decrease in Demand > Increase in Supply

When decrease in demand is proportionately more than increase in supply, then leftward shift in demand curve from DD to D1D1 is proportionately more than leftward stilt in supply curve from SS to S1S1 (Fig.). The new equilibrium is determined at E, equilibrium quantity falls from OQ to OQ1 and equilibrium price falls from OP to OP1


PRICE DETERMINITION .12

Case 3 Decrease in Demand < Increase in Supply

When decrease in demand is proportionately less than increase in supply, then leftward shift in demand curve from DD to D1D1

is proportionately less than rightward shift in supply curve from SS to SlS1 (fig.). The new equilibrium is determined at E1, equilibrium quantity rises from OQ to OQ1 whereas, and equilibrium price falls from OP to OP1.

(IV) Demand increases and Supply decreases

The effect of increase in demand and decrease in supply on equilibrium price and equilibrium quantity is discussed in the following three cases.Case 1: Increase in demand = Decrease in supply

When increase in demand is proportionately equal to decrease in supply, then rightward shift in demand curve from DD to D1D1 is proportionately equal to leftward shift in supply curve from SS to S1S1 (Fig.). The new equilibrium is determined at E1.



As the increase in demand is proportionately equal to the decrease in supply, equilibrium quantity remains the same at OQ, but equilibrium price rises from OP to OP1.

Case 2: Increase in Demand > Decrease in Supply

‘When increase in demand is proportionately more than decrease in supply; then rightward shift in demand curve from DO to DD is proportionately more than leftward shift in supply curve from 55 to SS (Fig.). The new equilibrium is determined at E1. As the increase in demand is proportionately more than the decrease in supply, equilibrium quantity rises from OQ to 0Q1 and equilibrium price rises from OP to OP1.



Case 3: Increase in Demand < Decrease in Supply

When increase in demand is proportionately less than decrease in supply then rightward shift in demand curve from DD to D1D1

is proportionately less than leftward shift in supply curve from SS to S1S1 (Fig.). The new equilibrium is determined at E1. As the Increase in demand is proportionately less than the decrease in supply, equilibrium quantity falls from OQ to OQ1

whereas, equilibrium price rises from OP to OP1.



SPECIAL CASES

Let us now discuss the effect on equilibrium price and equilibrium quantity in the following four special cases:

I. Change in Demand when Supply is Perfectly ElasticII. Change in Supply when Demand is Perfectly ElasticIII. Change in Demand when Supply is Perfectly InelasticIV. Change in Supply when Demand is Perfectly Inelastic

I. Change In Demand when Supply is Perfectly ElasticWhen supply is perfectly elastic, then change in demand does not affect the equilibrium price of the commodity. It only changes the equilibrium quantity. Original Equilibrium is determined at point E, when the original demand curve DD and the perfectly elastic supply curve SS intersect each other. OQ is the equilibrium quantity and OP is the equilibrium price. The change may be either an ‘Increase in Demand’ or ‘Decrease in Demand’.



a) Increase in Demand: When demand increases, the demand curve shifts to the right from PD to D1D1 (Fig), Supply curve 55 is a horizontal straight line parallel to the X-axis, Due to increase in demand for the product, the new equilibrium is established at E1. Equilibrium quantity rises from OQ to 0Q1 but equilibrium price remains same at OP as supply is perfectly elastic.

b) Decrease In Demand: When demand decreases, the demand curve shifts to the left from DD to D2D2 (Fig.). Supply curve SS is a horizontal straight line parallel to the X-axis. Due to decrease in demand, the new equilibrium is established at E2. Equilibrium quantity falls from OQ to OQ2 but equilibrium price remains the same at OP as supply is perfectly elastic.



II. Change In Supply when Demand as Perfectly ElasticWhen demand is perfectly elastic, then change in supply does not affect the equilibrium price of the commodity. It only changes the equilibrium quantity. Original Equilibrium is determined at point E, when the perfectly elastic demand curve DD and the original supply curve SS intersect each other. OQ is the equilibrium quantity and OP is the equilibrium price. The change may be either an increase in Supply’ or ‘Decrease in Supply’.

a) Increase in Supply When supply increases, the supply curve shifts to the right from SS to S1S1 (Fig.). Demand curve DD is a horizontal straight line parallel to the X-axis; Due to increase in supply for the product the new equilibrium is established at E1. Equilibrium quantity rises from OQ to OQ1 but equilibrium price remains the same at OP as demand is perfectly elastic.



b) Decrease in Supply: When supply decreases, the supply curve shifts to the left from SS to S1S1 (Fig.). Demand curve DD is a horizontal straight line parallel to the X-axis; Due to decrease in supply for the product, the new equilibrium is established at E2. Equilibrium quantity fails from OQ to OQ2 but equilibrium price remains same at OP due to perfectly elastic demand.



III. Change In Demand when Supply is Perfectly Inelastic

When supply is perfectly inelastic, then change in demand does not affect the equilibrium quantity. It only changes the equilibrium price. The change may be either an ‘Increase in Demand’ or ‘Decrease in Demand’. Here quantity supplied is fixed or constant supply.

a) Increase in Demand: When demand increases, the demand curve shifts to the right from DD to D1D1 (Fig.). Supply curve SS is a vertical straight line parallel to the Y-axis. Due to increase in demand for the product, the new equilibrium is established at E1. Equilibrium price rises from OP to OP1

but equilibrium quantity remains same at OQ as supply is perfectly inelastic.

b)Decrease in Demand: When demand decreases, the demand curve shifts to the left from DD to D2D2 (fig.). Supply curve SS is a vertical straight line parallel to the Y-axis. Due to decrease in demand, the new equilibrium is established at E2.



Equilibrium price falls from OP to OP2 but equilibrium quantity remains the same at OQ as the supply is perfectly inelastic.

IV. Change In Supply when Demand Is Perfectly InelasticWhen demand is perfectly inelastic, then change in supply does not affect the equilibrium quantity. It only changes the equilibrium price. The change may be either an ‘Increase in Supply’ or ‘Decrease in Supply’. Here quantity demanded is fixed or constant demand.

a) Increase in Supply:When supply increases, the supply curve shifts to the right from SS to S1S1 (Fig.). Demand curve DD is a vertical straight line parallel to the Y-axis. Due to increase in supply for the product, the new equilibrium is established at point E1. Equilibrium price falls from OP to OP1 but



equilibrium quantity remains the same at OQ as demand is perfectly inelastic.

b)Decrease in Supply: When supply decreases, the supply curve shifts to the left from SS to (fig.). Demand curve DD is a vertical straight line parallel to the Y-axis, Due to decrease in supply for the product, the new equilibrium is established at point E2, Equilibrium price rises from OP to OP2 but equilibrium quantity remains the same at OQ as demand is perfectly



inelastic.


eco ch 12 starting final

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