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Time Element and Price Determination under Perfect Competition!
Under perfect competition, price of the commodity is determined by the forces of demand and supply. Marshall, who propounded the theory says the price is determined by the forces of demand as well as supply. He also laid emphasis on the time element in the determination of price.
According to him, time plays a vital role in the determination of the price of the commodity, because when the demand for the commodity changes the supply cannot be changed in the same proportion. It takes time to bring changes in the supply of commodity.
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Marshall has divided the time into four categories from the view point of supply:
1. Market Period.
2. Short Period.
3. Long Period.
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4. Secular period.
It is worth mentioning that Marshall has not classified time on the basis of clock time, rather it has been done on the basis of operational time. Operational time means the time during which supply adjusts itself according to the change in demand.
Technical conditions of production do not allow the supply to adjust according to changes in demand conditions. It takes time to change size, scale and organisation of firms as well as industry.
1. Market Period:
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Market period is that period during which supply of commodity cannot be changed. It means supply cannot be increased beyond the stock of the commodity. In case demand increases the supply cannot be increased beyond the stock available. In market period, supply of the commodity remains constant. It is the demand that plays a vital role in determining the price of the commodity. The price will increase due to increase in demand and vice-versa.
2. Short Period:
Short period is that period under which the supply can be adjusted to a limited extent. During this time, the firms cannot bring change in the size of the plant. Production can be increased only by changing the variable factors of productions. It means production can be increased only by using the existing factors of production intensively. In short period also, neither the new firms can enter in industry nor the existing firms can leave the industry.
In the short period, demand will influence price more as compared to supply. The reason being, supply, can be increased up to a limited extent. Supply cannot be adjusted fully according to change in demand. The supply of commodity will be more in the short period as compared to that in market period.
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If demand for the commodity increases in the short period, supply of commodity can increase up to a limited extent.
3. Long Period:
Long period is that period of time under which factors of production can be adjusted fully according to the change in demand. In long period, the firms can change the size of the existing plants. New firms can enter in the industry and old firms can leave the industry. Thus, in long period supply can be adjusted according to change in demand.
4. Secular Period:
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It is also called very long period in which habits, population and technology, etc., also undergo a change.
It is clear from the above analysis that time plays a vital role in determining the price of commodity. The shorter the time, the more will be the influence of demand as compared to the supply.
Determination of Market Price:
Market price is the price of commodity, which prevails at any given point. Market price is determined by the equilibrium between demand and supply in a market period. Supply of commodity in the market period is limited by existing stock of the commodity. The market Period is so short that supply cannot be increased in response to increase in demand supply cannot be more than stock of commodity.
It is not essential that whatever, is available in stock, is offered for sale. Commodity offered for sale, out of the stock, depends upon the nature of the commodity, i.e., whether it is perishable or durable one. Perishable commodities like vegetables, milk, etc., cannot be stored for a longer period of time, due to nature of commodity.
The whole of stock is to be offered for sale, whatever may be the price of the commodity. Thus, the supply of the commodity will be perfectly inelastic in the short period. It means the supply of the commodity will remain constant. The price of the commodity is influenced by demand of commodity alone. Price of perishable commodities in the market period has been explained with the help of Fig. 8.8.
In the Fig. 8.8, SM is supply curve of the perishable commodity. It is parallel to Y-axis, Suppose DD is the original demand curve. It intersects supply curve at point E. 0P will be the market price.
If demand increases, the demand curve will shift to the right of the original demand curve (DD). E1 will be new equilibrium point. The price will increase from 0P to 0P1. On the other hand, if demand decreases, the demand will shift to the left of the original demand curve. The new demand curve D2D2, intersects supply curve at point E2. The market price will reduce from 0P to 0P2.
Supply of the perishable commodities are limited by the existing stock. But in case of durable commodities, it is not so. The reason being, such commodities can be stored for a longer period of time. Therefore, the seller will not sell all the stock of commodity at a given price.
He will wait for some time in anticipation of earning more profit. Seller will sell less quantity at low price and vice-versa. At a particular price level he will be ready to sell entire stock of commodity and at a certain minimum price, he will prefer to keep all commodity as a stock. In the former case, supply is equal to stock and in latter case, supply is equal to zero. Supply of the commodity will be elastic in these two extremes. The price at which a seller will refuse to sell his commodity is called Reserve Price.
There are several factors which govern the reserve price.
These are as follows:
1. It depends upon the seller’s expectation regarding future price of the commodity. If he expects higher future price, reserve price will be higher and vice-versa.
2. The seller’s liquidity preference is another factor. The reserve price will be lower in case of higher liquidity preference and vice-versa.
3. The reserve price also depends upon the durability of the commodity. Higher the durability of the commodity, higher will be the reserve price.
The above analysis usually explains that market price is influenced more by demand factor. Supply of commodity remains constant during market period. The price of the commodity changes due to change is demand.
The price determination of durable commodity has been explained with the help of Fig. 8.9.
The supply curve RS is elastic from R to E1 and inelastic beyond E1 total stock of the commodity is 0M1. Suppose DD is the original demand curve. It intersects supply curve at point E. 0P price is equilibrium price. At this price 0M quantity is offered for sale, which is less than total stock. The seller will keep MM1, quantity as a stock if the demand for commodity increases.
The demand curve will shift from DD to D1D1. The new equilibrium price will be 0P1. At this price whole stock of the commodity will be offered for sale. On the other hand, if demand increases further, the demand curve will shift from D1D1 to In this case, only price will increase.
Determination of Short-Period Price:
Short-period price is determined by forces of demand and supply. Under perfect competition, supply curve of the industry in the short period is the summation of short run cost curves of the firms. Supply curve of industry is positively sloped in the short period. The supply curve of industry lies above minimum of average variable cost.
The process of price determination has been explained with the help of the Fig. 8.10.
In the fig. MS and SRS are market period and short run supply curves, respectively. D1D1 is the original demand curve. E1 is the equilibrium point, where demand curve (DD) and short run supply curve (SRS) intersect each other. 0P1 is the equilibrium price. This is also market price because market supply curve (MS) also intersects demand curve (D1D1) at point E1.
If demand increases, the new demand curve (D2D2) intersects market supply curve (MS) at point E3 and short run supply curve (SRS) at point E2. The price in the short period increases from 0P1 to 0P2 and supply of the commodity increases from 0Q to 0Q1.
In comparison to short run price, market price is fixed at 0P3 which is higher than short run period price due to inelastic supply of commodity. But the short period price 0P2, is higher than original price 0P. The reason being, when the production is increased, the marginal cost of commodity increases.
On the contrary, when the demand decreases, it will cause shift of the demand curve to the left of original demand curve (D1D1). The new demand curve will be D3D3. The new demand curve (D3D3) intersects market supply (MS) at A and short period supply curve (SRS) at E0.
Determination of Long Period or Normal Price:
Long-period price is also known as normal price. Normal price is determined by the long run forces of demand and supply. Firms in the industry can vary the size of plant. New firms can enter in the industry and existing firms can leave the industry.
Supply can be adjusted fully according to the change in demand. Normal price never remains constant. Normal price undergoes change with change in demand and supply forces. The process of normal price determination has been explained in the Fig. 8.11.
In the Fig. 8.10, LRS, SRS and MPS are the long run, short run and market period supply curve, respectively. DD is the original demand curve. E is the equilibrium price and 0Q is the equilibrium output. With increase in demand, the new demand curve will be D1D1 and this demand curve cuts LRS, SRS and MPS at point E1, E2 and E3. 0P1, 0P2 and 0P3 will be new equilibrium prices.
These prices vividly reveals that long period price 0P1 will be less than short period price 0P2 and market price 0P3. The reason being, is long run all inputs can vary and supply can be adjusted according to change is demand, whereas, in short period only variable factors of production can vary and market price is higher (0P3) as compared to short-period and long-period prices.
In market period, the supply of the commodity remain constant. Thus, during long period, more quality is offered for sale (0Q1) as compared to short period (0Q2), on the other hand, if demand decreases the new demand curve will be D2D2. It intersects LRS, SRS and MPS at points E6, E5 and E4, respectively.
New equilibrium prices will be 0P6, 0P5 and 0P4, respectively. Thus, with decrease in demand, in long period and short period, the less amount if commodity 0Q6 and 0Q5 will be offered for sale in the market. The firms in the industry in the long period will reduce their output.
Normal Price and Returns to Scale:
Long run normal price is determined by the long run equilibrium between demand and supply. In the long run the supply curve does not have any definite slope. The reason being, cost of production is influenced by returns to scale. Thus, the slope of supply curve will be different accordingly.
In the long run, under perfect competition supply curve can have three possible slopes:
(i) When the production in the industry is according to increasing returns or diminishing cost the slope of the industry supply curve will be negative.
(ii) When the production in the industry is according to diminishing returns or increasing cost, the slope of the industry supply curve will be positive.
(iii) When the production in industry is according to constant returns or constant cost, the supply curve will be parallel to X-axis.
Thus, returns to scale influence the normal price to a consider table extent.
Determination of Normal Price in Decreasing Returns or Increasing Cost Industry:
Increasing cost industry means when the size of the industry expands, the cost of production of firms in the industry enhances considerably. The reason being, it experiences certain external economies and diseconomies. But diseconomies in case of increasing cost industry overweight the external economies.
It will cause increase in the cost of production. Consequently, supply curve of the industry rises from left to right. When industry expands then average minimum cost of production of the firms enhances. Normal price under increasing cost has been explained in the Fig. 8.12.
In the Figure, long run supply (LRS) curve has a positive slope. DD is the original demand curve. 0P is the equilibrium curve. If demand increases, it will cause the shift of demand curve to right of original demand curve (DD). The new demand curve (D1D1) intersects LRS curve at point E1. 0P1 is the equilibrium price.
Price increases due to increase in cost of production. On the contrary, if demand decreases demand curve will shift to left of the original demand curve (DD). The new demand curve (D2D2) intersects LRS curve at point E2. The equilibrium price reduces from 0P to 0P2. The industry supplies 0M2 quantity at this equilibrium price.
Determination of Normal Price in Increasing Returns or Diminishing Cost Industry:
Diminishing cost industry means when industry expands, the cost of production of firms in the industry declines. The reason being, firms experience more external economies as compared to external diseconomies. In other words external economies overweigh the external diseconomies in case of diminishing cost industry.
Thus, in case of a decreasing cost industry, the additional supplies of the product will be forthcoming at reduced cost. The supply curve of industry will have a negative slope.
The normal price in case of diminishing cost industry has been explained with the help of Fig. 8.13. In the Figure, LRS curve slopes downwards from left to right. D0D0 is the original demand curve. E0 is the equilibrium point and 0P0 is the equilibrium price.
If demand increases, the demand curve will shift from D0D0 to D1D1. The new demand curve (D1D1) intersects LRS curve at point E1. 0P1 is the new equilibrium price, which is lower than the original equilibrium price (0P). The reason being, law of increasing returns operates in the industry.
On the contrary, if demand decreases, the demand curve will shift to the left of original demand curve (D0D0). The new demand curve (D2D2) intersects (LRS) supply curve at point E2. The new equilibrium price is 0P2, which is higher than the original equilibrium price (0P0).
Supply will decrease, due to decrease in demand. Therefore, in case diminishing cost industry, with increase in demand industry offers more quantity at reduced price.
Determination of Normal Price in Constant Returns or Constant Cost Industry:
Constant cost industry is that industry in which external economies as well as diseconomies cancel each other. The cost of firms in the industry remains constant, with the change in industry.
The long run supply curve of the constant cost industry is a horizontal straight line at the level of long run minimum average cost.
The process of price determination under constant cost industry has been explained in the Fig. 8.14. LRS is long run supply curve.
In the Figure LRS curve is the horizontal straight line parallel to X-axis. DD is the original demand curve, 0P is the equilibrium price. If demand increases the demand curve will shift from DD to D1D1. The new demand curve (D1D1) intersects LRS curve at point E1. The 8.14 Figure reveals that the price has not undergone any change despite the increase in demand.
But the supply of the commodity has increased from 0M to 0M1. The reason being there is no change in cost of production. On the contrary, if demand decreases, the demand curve will shift to left of original demand curve (DD). E2 is the equilibrium point. In this situation, there is no change in price of the commodity, but supply of the commodity decreases. Thus, under the constant cost industry, with the change in demand the price of the commodity remains constant. The reason being, cost of product of industry remains constant.
From the above discussion, it is clear that as demand increases, the long run normal price increases, remains the same or decreases depending upon whether the industry in question is an increasing cost, constant cost or decreasing cost industry.
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