Elementary Theory of Price Determination: Demand, Supply & Equilibrium Price

12 months ago

Atiqur Rahman

9 minutes

One of the main objectives of microeconomic theory is the determination of price. Most of the earlier economists had different views regarding the importance of demand & supply in the determination of price. We have three approaches regarding this.

● According to Classical Economists (like Adam Smith and David Ricardo) determination of price depends upon the cost of production of a good. Some of socialist economists (like Robert Owen, Sismondi, and Karl Marx) are also satisfied with the wording of classical economists. According to them, sellers will supply goods until the price equals marginal cost.

● According to Marginalist Economists (like Menger and Jevons), the determination of price depends upon the utility that an individual is deriving from the consumption of a commodity. In simple terms, the determination of price depends upon the demand.

● Prof. Marshall combined the above two approaches and gave a new approach regarding the determination of price. According to him determination of price depends upon both supply (cost of production) and demand (marginal utility). So the demand & supply are like two blades of a scissor that are needed to cut a piece of cloth.

Equilibrium Price:

The equilibrium price is the price at which the quantity supplied equals the quantity demanded. At the equilibrium price, all the sellers succeed in selling the quantity of the commodity that they wish to sell in the market, and all the buyers succeed in buying the quantity of the commodity that they wish to buy. Once equilibrium is achieved, there is no tendency on the part of the consumers & producers to move away from it.

Two factors that determine equilibrium price and quantity are (i) Demand and (ii) Supply. The process of determination of price includes interaction between demand and supply.

The equilibrium price is the price at which quantity supplied equals quantity demanded.

Demand:

A commodity is demanded because of the utility that an individual is deriving from its consumption. The objective of the consumer is to maximize utility (or satisfaction). As consumer consumes more units of a commodity, its marginal utility goes on diminishing.

The marginal utility is a change in total utility due to the consumption of one more unit of the commodity. The maximum price that a consumer is willing to pay for a good will be its marginal utility because a rational consumer is not ready to pay more than marginal utility (or more than his satisfaction).

Supply:

The objective of the seller is to maximize its profit. He wants to cover at least the monetary cost of producing that commodity & that monetary cost is equal to the marginal cost of production. So he is not ready to sell a commodity for a price less than the marginal cost of production.

Interaction between Demand and Supply:

The price of a commodity is determined by forces of supply & demand. The demand and supply schedules are shown in table 1.

In the above table, column (1) shows the prices, column (2) shows the quantity demanded, column (3) shows the quantity supplied column, (4) shows the difference between quantities supplied & quantity demanded. Column (5) shows the equilibrium, and column (6) shows the pressure on price due to the difference between the quantity demanded and the quantity supplied.

Elementary Theory of Price Determination

When the price is Rs. 5, the quantity demanded is 20 units, and the quantity supplied is 100 units. At a price of Rs 5 quantity supplied is greater than the quantity demanded by 80 units. This excess of supply over demand results in excess supply.

When the price is Rs. 4, the quantity demanded is 40 units, and the quantity supplied is 80 units. At a price of Rs 4 quantity supplied is again greater than the quantity demanded by 40 units. This excess of supply over demand again results in excess supply.

When the price is Rs. 1, the quantity demanded is 100 units, and the quantity supplied is 20 units. At a price, Rs 1 quantity demanded is greater than the quantity supplied by 80 units. This excess of demand over supply results in excess demand.

When the price is Rs. 2, the quantity demanded is 80 units and the quantity supplied is 40 units. At a price of Rs 2 quantity demanded is again greater than the quantity supplied by 40 units. This excess of demand over supply results in excess demand.

It is only when the price is Rs. 3 that both the quantity demanded & quantity supplied is equal to 60 units. This point is the equilibrium point because the quantity demanded is equal to the quantity supplied & there is neither excess demand nor excess supply.

The interaction of demand and supply gives rise to three situations. These are:

(i) Excess supply (Supply>Demand): The excess of supply over demand results in excess supply. It is evident from Table 1 that when the price is Rs.5, there will be 80 units (100-20 units) of excess supply, and when the price is Rs. 4, excess supply is 40 units (80- 40 units). This excess supply will put pressure on prices to fall down until reaches equilibrium.

(ii) Equilibrium (Supply=Demand): Equilibrium exists when demand is equal to supply. It is evident from Table 1 that when the price is Rs 3, the quantity demanded is equal to the quantity supplied. Hence there will not be any pressure on the price to move either upward or downward.

(iii) Excess Demand (Supply<Demand): The excess of demand over supply results in excess demand. It is evident from Table 1 that when the price is, excess demand is 80 units (20-100 units), and when the price is Rs 2, excess demand is 40 units (40-80 units). This excess demand will put pressure on prices to go up until reaches equilibrium.

Figure 1 represents all three situations that can arise. The quantity demanded, and quantity supplied is measured on the X-axis, and the price of the commodity is on the Y-axis. DD is the demand curve which shows the negative relationship between price & quantity demanded. SS is the supply curve which shows the positive relationship between price & quantity supplied.

Demand and supply curves intersect each other at point E, and this is known as a unique equilibrium point. The equilibrium point signifies that the equilibrium price is Rs 3 and the equilibrium quantity is 60 units. The price above Rs 3 shows the extent of excess supply, and the price below Rs 3 shows the extent of excess demand.

The situation of excess demand or excess supply is automatically wiped out through a price mechanism. Under this, in case of excess demand, the price will tend to increase, and in case of excess supply, the price will tend to decrease.

𝐷𝑒𝑚𝑎𝑛𝑑 > 𝑆𝑢𝑝𝑝𝑙𝑦 ⇒ 𝐸𝑥𝑐𝑒𝑠𝑠 𝐷𝑒𝑚𝑎𝑛𝑑

𝐷𝑒𝑚𝑎𝑛𝑑 = 𝑆𝑢𝑝𝑝𝑙𝑦 ⇒ 𝐸𝑞𝑢𝑖𝑙𝑖𝑏𝑟𝑖𝑢𝑚

𝐷𝑒𝑚𝑎𝑛𝑑 < 𝑆𝑢𝑝𝑝𝑙𝑦 ⇒ 𝐸𝑥𝑐𝑒𝑠𝑠 𝑆𝑢𝑝𝑝𝑙𝑦

Elementary Theory of Price Determination: Demand, Supply & Equilibrium Price

Equilibrium Price:

Demand:

Supply:

Interaction between Demand and Supply:

The interaction of demand and supply gives rise to three situations. These are:

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Equilibrium Price:

Demand:

Supply:

Interaction between Demand and Supply:

The interaction of demand and supply gives rise to three situations. These are:

Read More- Microeconomics

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Related

Share Your ThoughtsCancel reply