Unit 2: Determination of Prices Chapter Notes | Business Economics for CA Foundation PDF Download

Introduction

• Prices reflect the exchange value of goods and services. They indicate the value of services provided by factors of production like land, labor, capital, and organization, in the form of rent, wages, interest, and profit.
• Therefore, understanding how prices are determined is crucial in Economics.
• Prices reflect the exchange value of goods and services. They indicate the value of services provided by factors of production like land, labor, capital, and organization, in the form of rent, wages, interest, and profit.
• Therefore, understanding how prices are determined is crucial in Economics.
• In a free market, the equilibrium price is set when demand and supply are in balance without any outside interference.

 Government Intervention 

•  Sometimes, the government steps in to set prices, either fully or partially. For example, in India, the government fixes the prices of essential inputs like petrol, diesel, and fertilizers, as well as the procurement prices of crops like wheat and rice. 
•  When setting these prices, the government considers factors like production costs, business risks, and the nature of the product. 

 Importance of Demand and Supply Model 

•  Studying the demand and supply model is crucial because it helps explain how markets function. Understanding these market forces allows us to interpret changes in equilibrium prices and quantities across various products and factors. 
•  By applying the principles of demand and supply, we can predict potential market outcomes in real-world scenarios. 
•  Businesses can leverage the demand and supply model to anticipate the impacts of different economic and non-economic factors on equilibrium prices and quantities. 
•  For instance, the effects of government actions like taxation, subsidies, and price controls can be analyzed using this equilibrium framework. 

Price Determination in a Competitive Market

Equilibrium Price:

• The equilibrium price, also known as the market clearing price, is the price at which the quantity demanded equals the quantity supplied. At this price, there is neither excess supply nor excess demand.
• To understand how equilibrium price is determined, we need to look at the demand and supply of a commodity in the market.

Schedule for Price Determination:
The following schedule shows the relationship between price, demand, and supply for a particular commodity:

Graphical Representation:
When the data from the above schedule is plotted on a graph with price on the Y-axis and quantity demanded and quantity supplied on the X-axis, it visually represents the points of equilibrium.

Achieving Stable Equilibrium:

• Stable Equilibrium is achieved when the market price settles at the equilibrium price, such as ₹ 2 in the example.
• At this point, the market is in balance, and any disturbances will self-correct, bringing the market back to equilibrium.

Price Mechanism in Stable Equilibrium:

• If the market price is above the equilibrium price, for example, ₹ 15, there will be excess supply. Sellers will lower their prices to clear their unsold stock.
• As prices fall, quantity demanded increases and quantity supplied decreases, reducing the supply-demand gap and restoring equilibrium.

When the market price is below the equilibrium, like at ₹ 5 in this example, a shortage occurs because the quantity demanded is greater than the quantity supplied. This shortage drives the price up, as buyers who cannot get enough of the good are willing to pay more. As the price rises, the quantity demanded decreases and the quantity supplied increases, and vice versa. This process continues as long as demand exceeds supply.Eventually, the market reaches a point where the quantity supplied matches the quantity demanded. At the equilibrium price of ₹ 10, the supply decisions of firms align with the demand decisions of buyers. This automatic adjustment through price movements helps eliminate shortages and surpluses, restoring equilibrium in the market.

Changes in Demand and Supply

Introduction

• Market Equilibrium: The initial analysis of market equilibrium was based on the ceteris paribus assumption, meaning all other factors were held constant.
• Real-World Dynamics: In reality, factors influencing demand (such as income, preferences, population, etc.) and supply (like production costs, technology, etc.) constantly change, leading to shifts in demand and supply.
• Impact on Equilibrium: These shifts affect the equilibrium price and quantity in the market.

Possible Changes in Demand and Supply:

• Increase in Demand: When demand increases, it shifts to the right.
• Decrease in Demand:. decrease in demand shifts it to the left.
• Increase in Supply: An increase in supply shifts it to the right.
• Decrease in Supply:. decrease in supply shifts it to the left.

Increase in Demand

• Initial Equilibrium: The original demand curve (DD) and supply curve (SS) intersect at equilibrium price (OP) and quantity (OQ).
• Shift in Demand: When consumer income increases, the demand curve shifts to the right (D₁D₁), while the supply curve remains the same.
• New Demand at Old Price: At the original price (OP), the new demand (D1D₁) exceeds the supply (OQ), creating excess demand (QQ₂).
• Price Increase: Due to excess demand, the price rises to OP₁.
• Supply Response: Higher prices incentivize an increase in quantity supplied, moving along the supply curve.
• New Equilibrium:. new equilibrium is reached at price (OP₁) and quantity (OQ₁), where demand and supply balance.
• Conclusion: An increase in demand leads to higher equilibrium prices and quantities, as both the quantity supplied and quantity sold increase.
  

Decrease in Demand:

• Initial Situation: When demand is strong, the market operates at a certain equilibrium with a specific price and quantity.
• Shift in Demand: If there is a decrease in demand, for instance, due to a drop in consumer income, the demand curve shifts to the left (from D to D₁).
• Supply Remains: The supply curve remains unchanged during this period.
• Impact at Original Price: At the original price (OP), the quantity demanded falls to OQ₂, while the quantity supplied remains at OQ. This creates a situation where supply exceeds demand.
• Price Adjustment: With excess supply, the price begins to fall. As the price decreases, the quantity demanded starts to increase.
• New Equilibrium:. new equilibrium is eventually reached at a lower price (OP₁), where the quantity demanded (OQ₁) matches the quantity supplied (OQ₁).
  

Increase in Supply: Now, let's consider a scenario where demand remains constant, but there is an increase in supply, perhaps due to advancements in technology.

• In this case, the supply curve (SS) shifts to the right, becoming S₁S₁. Initially, at the equilibrium price (OP), the quantity demanded (OQ) is met with a quantity supplied (OQ₂) based on the new supply curve.
• At this original price, a surplus occurs. This surplus triggers a decrease in the equilibrium price and an increase in the quantity demanded. Eventually, a new equilibrium price (OP₁) is established, where the quantity demanded (OQ₁) matches the quantity supplied (OQ₁).

Therefore, when supply increases while demand remains unchanged, the equilibrium price decreases, and the quantity demanded increases.

Decrease in Supply: Now, let's explore a situation where supply decreases due to outdated technology. In this scenario, the supply curve (SS) shifts to the left, becoming S₁S₁.

• At the original equilibrium price (OP), the quantity demanded (OQ) exceeds the quantity supplied (OQ₂) based on the new supply curve. This creates a deficit at the original price, leading to an increase in the equilibrium price and a decrease in the quantity demanded.
• Eventually, a new equilibrium price (OP₁) is reached, where the quantity demanded (OQ₁) matches the quantity supplied (OQ₁).

Consequently, when supply decreases, the equilibrium price rises, but the quantity sold and purchased decreases, as illustrated in the scenario.

Simultaneous Change in Demand and Supply

(a) When an Increase in Demand is Equal to an Increase in Supply:

• Original Equilibrium: The initial demand curve (DD) and supply curve (SS) intersect at point E, establishing the equilibrium price (OP) and quantity (OQ).
• New Equilibrium: With an equal increase in demand and supply, the new curves (D₁D₁ and S₁S₁) intersect at point E₁.
• Impact on Price and Quantity: The new equilibrium price remains the same as the old price (OP), but the equilibrium quantity increases.

(b) When an Increase in Demand is Greater than an Increase in Supply:

• Original Equilibrium: Same as above, where the initial curves (DD and SS) meet at point E.
• New Equilibrium: With a greater increase in demand compared to supply, the new curves intersect at a higher price point.
• Impact on Price and Quantity: The new equilibrium price (OP1) rises above the old price (OP), indicating a significant increase in demand relative to supply.

(c) When an Increase in Supply is Greater than an Increase in Demand:

• Original Equilibrium: As before, where the initial demand and supply curves intersect at point E.
• New Equilibrium: With a greater increase in supply compared to demand, the new curves intersect at a lower price point.
• Impact on Price and Quantity: The new equilibrium price falls below the original price, reflecting the greater impact of supply increase.

(d) When a Decrease in Supply is Greater than a Decrease in Demand:

• Original Equilibrium: Initial intersection of demand and supply curves at point E.
• New Equilibrium: With a more significant decrease in supply compared to demand, the new equilibrium price rises.
• Impact on Price and Quantity: The equilibrium price increases, reflecting the greater impact of supply decrease.

Summary of Outcomes:

• Increase in Demand and Supply: Equilibrium quantity increases; change in equilibrium price is uncertain.
• Decrease in Demand and Supply: Equilibrium quantity decreases; change in equilibrium price is uncertain.

When the demand and supply curves shift in opposite directions, the effects on equilibrium price and quantity can vary significantly. Let's explore this scenario:

1. Simultaneous Shifts: - When the demand curve shifts to the right (increased demand) while the supply curve shifts to the left (decreased supply), there are two possible outcomes depending on the magnitude of the shifts.

2. Case (a): Strong Increase in Demand - In this case, the increase in demand is greater than the decrease in supply. 
Outcome: Both equilibrium price and equilibrium quantity rise.
Explanation: The stronger demand pull outweighs the supply drop, leading to higher prices and a larger quantity sold.

3. Case (b): Strong Decrease in Supply - Here, the decrease in supply is greater than the increase in demand. 
Outcome: Equilibrium price rises, but equilibrium quantity falls. 
Explanation: Even though demand is up, the significant drop in supply constricts the quantity available, leading to higher prices but lower quantities sold.

4. General Observation: - In both scenarios, the equilibrium price increases from P to P₁ as the equilibrium point moves from E to E₁. - However, the effect on quantity can vary: - In Case (a), the equilibrium quantity increases. - In Case (b), the equilibrium quantity decreases.

5. Key Insight: - When demand increases and supply decreases, the actual quantity bought and sold can vary depending on the relative shifts of the curves. - A curve that shifts more significantly will have a greater impact on the quantity bought and sold.

6. Summary of Outcomes: - When Demand Increases and Supply Decreases: 

• Equilibrium price rises. - Equilibrium quantity change is uncertain.

When Demand Decreases and Supply Increases

• Equilibrium price falls. - Equilibrium quantity change is uncertain.In summary, the interaction between shifting demand and supply curves can lead to different outcomes for equilibrium price and quantity, depending on the relative magnitude of the shifts.