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Determination of price

In an open competitive market, it is the interaction between demand and supply that determines price.
 
This can be shown by the following schedule and diagram.
 

Price of commodity X

Demand for commodity X

₹ 10

100 Units

₹ 20

50 Units

₹ 30

25 Units

 
Market demand schedule is inversely related to the price. Hence the demand curve slopes downwards from left to right.

Market Supply Schedule

Price of commodity X

Supply of commodity X

₹ 10

25 Units

₹ 20

50 Units

₹ 30

100 Units

 
Market supply schedule is directly related to the price. Hence the supply curve slopes upwards from left to right.
 
The above two tables if put together, gives us an idea of equilibrium price and output.
 

Price of commodity X

Supply of commodity X

Supply of commodity

₹ 10

25 Units

25 Units

₹ 20

50 Units

50 Units

₹ 30

100 Units

100 Units

 
At ₹ 20 the quantity demanded is equal to quantity supplied. It is called as the Equilibrium Price.
 
The above table can be represented graphically:
 
Description: 20353.png
 
The market demand and supply curves intersect each other at point E, where the quantity demanded is equal to quantity supplied. At any other point, either quantity demanded is greater than quantity supplied or quantity supplied is more than quantity demanded. Accordingly price will move up or come down till it secures a balance between the two opposite forces. ₹ 20 is the equilibrium price and 50 units is the equilibrium quantity.

Equilibrium of a business firm

A business firm is said to be in equilibrium when it maximizes its profit and has no intension either to increase or decrease its output. Business firms in a perfect competition market are ‘Price takers’. This is because there are large number of firms in the market who are producing identical or homogeneous product. As such these firms cannot influence the price in their individual capacity. They have to accept the price fixed by the industry. A competitive firm thus is not a price determinator but an output adjuster.
 
A business firm will produce that much output, where its profits are maximum. In perfect competition whether the output is large or small, price per unit will remain the same. It is a peculiar feature of such a market. Prices being fixed for all the units, the firms price will be equal to average and marginal revenue {Price = Average revenue = Marginal revenue}. This can be shown in the following table:
 

Quantity sold

Price per unit

Total revenue

Average revenue

Marginal revenue

8

2

16

2

2

10

2

20

2

2

12

2

24

2

2

14

2

28

2

2

16

2

32

2

2

 
Rotal revenue = Price X Quantity {Total sales receipt}
 
Average revenue = Total revenue / Quantity {revenue from selling a single unit}
 
Marginal revenue = Total revenuen – Total revenuen–1. {n = present unit, n–1 = previous unit}[Revenue from selling an additional unit]
 
This can be depicted in the form of a diagram:
 
Description: 20396.png
 
With a given price a firm in such a market produces the output to the point where Marginal Revenue [MR] is equal to Marginal Cost [MC]. i.e., MR = MC.
 
If MR is greater than MC, there is always an incentive for the firm to expand its production further and gain by the sale of additional units. On the other hand if MC is greater than MR, then the firm will have to reduce its output. Since an additional unit adds more to the expenses than revenue.
 
Hence, when MR = MC, profits are maximum.
 
Description: 20409.png
 
The equality of MR and MC is the necessary condition but not a sufficient condition. The sufficient condition is that MC must cut the MR curve from below. If MC curve cuts MR curve from above, then the point of intersection will not be the point of equilibrium output as the firm will be able to earn more by producing more. MC curve cuts MR curve at 2 points/places, points T and R respectively. But at point ‘T’, MC is cutting MR from above. Hence point ‘T’ is not the point of equilibrium as the sufficient condition is not satisfied. The firm will benefit if it goes beyond point ‘T’ as the additional cost of producing an additional units is falling. At point R, the MC curve is cutting MR curve from below. Hence, point ‘R’ is the point of equilibrium. OQ2 is the equilibrium level of output.




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