CA Foundation Business Economics Study Material – Determination of Prices

CA Foundation Business Economics Study Material Chapter 4 Price Determination in Different Markets – Determination of Prices

Determination of Equilibrium Price

• We know that law of demand reveals, if other conditions remain unchanged, more quantity of a commodity is demanded in the market at a lower price and less quantity is demanded at a higher price. Therefore, demand curve slopes downward.
• Similarly, the law of supply reveals, if other conditions remain unchanged, more quantity of a commodity is supplied in the market at a higher price and less quantity is supplied at a lower price. Therefore, supply curve slopes upward.
• Demand and supply are the two main factors that determine the price of a commodity in the market. In other words, the price of a commodity is determined by the inter-action of the forces of demand and supply.
• The price that will come to prevail in the market is one at which quantity demanded equals 1 quantity supplied.
• This price at which quantity demand equals quantity supplied is called equilibrium price.
• The quantity demanded and supplied at equilibrium price is called equilibrium quantity.

The process of price determination is illustrated with the help of following imaginary schedule and diagram.

The above table shows that at a price of ₹ 3 per unit, the quantity demanded equals quantity supplied of the commodity. At ₹ 3 two forces of demand and supply are balanced. Thus, ₹ 3 is the equilibrium price and equilibrium quantity at ₹ 3 is 300 units.

• The equilibrium between demand and supply can also be explained graphically as in Fig.
• In Fig. the market is at equilibrium at point ‘E’, where the demand curve and supply curve intersect each other. Here quantity demanded and supplied, are equal to each other.
• At point ‘E’, the equilibrium price is ₹ 3 per unit and equilibrium quantity is 300 units.
• If the price rises to ₹ 4 per unit, the supply rises to 400 units but demand falls to 200 units. Thus, there is excess supply of 200 units in the market.
• In order to sell off excess supply of 200 units the sellers will compete among themselves and in doing so the price will fall.
  As a result the quantity demand will rise and quantity supplied will fall and becoming equal to each other at the equilibrium price ₹ 3.
• Similarly, if the price falls to ₹ 2 per unit, the demand rises to 400 units but supply falls to 200 units. Thus, there is excess demand of 200 units in the market.
• As the price is less there is competition among the buyers to buy more and more. This competition among buyers increases with the entry of new buyers.
• More demand and less supply and competition among buyers will push up the price.
• As a result, quantity demanded will fall and quantity supplied will rise and become equal to each other at the equilibrium price of ₹ 3.

Effects of Shifts in Demand and Supply on Equilibrium Price

While determining the equilibrium price, it was assumed that demand and supply conditions were constant. In reality however, the condition of demand and supply change continuously.
Thus, changes in income, taste and preferences, changes in the availability and prices of related goods, etc. brings changes in demand conditions and cause demand curve to shift either to right or left.
In the same way, changes in the technology, changes price of labour, raw materials, etc., changes in the number of firms, etc. brings changes in supply conditions and cause supply curve to shift either to right or left.

(a) Change (shift) in Demand and Supply remaining constant.

• In Fig.- DD and SS are the original demand and supply curves respectively intersecting each other at point E.
• At point E, the equilibrium price is OP and the demand and supply (ie. equilibrium quantity) are equal at OQ.
• When the demand increases, the demand curve shifts upwards from DD to D₁D₁ supply remaining the same.
  As a result, the equilibrium price rises from OP to OP₁ and the equilibrium quantity increases from OQ to OQ₁ as shown at point E₁.
• When the demand decreases, the demand curve shifts downwards from DD to D₂D₂, Supply remaining the same.
• As a result, the equilibrium price falls from OP to OP₂ and the equilibrium quantity decreases from OQ to OQ₂ as shown at point E₂.

(b) Change (shift) in Supply and Demand remaining constant.

• In Fig. – DD and SS are the original demand and supply curves respectively inter-sections each other at point E.
• At point E, the equilibrium price is OP and the demand and supply (i.e. Equilibrium quantity) are equal at OQ.
• When the supply increases, the supply curve shifts to the right from SS to S₁S₁ demand remaining the same.
• As a result, the equilibrium price falls from OP to OP₁ and the equilibrium quantity increases from OQ to OQ₁ as shown at point E₁.
• When the supply decreases, the supply curve shifts to the left from SS to S₂S₂, demand remaining the same.
• As a result, the equilibrium price rises from OP to OP₂ and the equilibrium quantity decreases from OQ to OQ₂ as shown at point E₂.

Effects of Simultaneous Shifts in Demand and Supply on Equilibrium Price

Sometimes demand and supply conditions may change at the same time changing the equilibrium price and quantity. The changes in both demand and supply simultaneously can be discussed with the help of following diagrams:

• In Fig. – DD and SS are the original demand and supply respectively intersecting each other at point E at which the equilibrium price is OP and the equilibrium quantity is OQ.
• Fig. (a) shows that the increase in demand is equal to increase in supply. The new curves D₁D₁ and S₁S₁ intersect at E₁. Therefore, the new equilibrium price is equal to old equilibrium price OP. But equilibrium quantity increases.
• Fig. (b) shows that the increase in demand is more than increase in supply. The new curves D₁D₁ and S₁S₁ intersect each other at point E, which shows that new equilibrium price OP₁ is higher than old equilibrium price OP. But equilibrium quantity increases.
• Fig. (c) shows that the increase in supply is more than increase in demand. The new curves D₁D₁ and S₁S₁ intersect each other at point E₁ which shows that new equilibrium price OP₁ is lower than old equilibrium price OP. But equilibrium quantity increases.