theory of price and output determination

8/13/2019 Theory of Price and Output Determination

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What do we men by market ?

In general sense market refers to a place wheregoods are sold. But in economics market refers to

place where buying and selling of goods andservices takes place.

In broad sense it is a mechanism where people

get involved in selling and buying of goods andservices.

There is no need of place of transaction, just it

requires buyers, sellers, price of the commodityand the amount of the commodity.

Economists have developed different marketmodels to explain the process of price and outputdetermination.


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Those are depending upon number of firms in themarket, the degree of market power of firm inaffecting the price of the product, types of

products (identical or differentiated), and son on.The major market structures categorized by theeconomists are perfect competition, monopoly,

monopolistic competition and oligopoly.Here, we just study about the process of priceand output determination under perfectcompetition and monopoly market structure.

Before proceeding to the discussion on price andoutput determination under perfect competitionand monopoly market we need to know aboutthe concept of the equilibrium of the firm.


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EQUILIBRIUM OF THE FIRM

The word 'equilibrium' means a state of balance.When two opposing forces working on an object arein balance so that the objects has no tendency tochange, it is said to be in equilibrium.

In other words, when the objects under the pressure

of forces working in opposite directions has notendency to move in either direction, the object issaid to be in equilibrium.

Similarly, a firm is said to be in equilibrium when ithas no tendency to change its level output.

That means the firms equilibrium is a condition inwhich the firm neither want to increase nordecrease its level of output.


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At the equilibrium condition the firm will producethe equilibrium level of output and will chargethe price at which the equilibrium output can besold in the market.Major objectives of a firm is to maximizemaximize its profit and to minimize the cost of

production.The firms profit maximization objectives isfulfilled when the firm is in equilibrium

condition.There are two approaches to explain theequilibrium of the firm;

1. TR-TC Approach.


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1 . TR TC Approach of Determining Equilibrium Level ofOutput

The TR-TC approach uses the concept of totalrevenue (TR) and total cost (TC) to determine theequilibrium of a firm.

Firms objective is to maximize its profit and

according to this approach, a firm will maximize itsprofit when the difference between total revenue(TR) and total cost (TC) is maximum.

According to this approach, an equilibrium positionwill be determined at the point where thedifference between total revenue and total cost ishighest.

Hence, total profit is the difference between total


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i.e . = TR TC

Where,

= Total Profit,TR = Total Revenue and

TC = Total Cost.

In above formula, we can see three cases;i. When TR > TC then there exist excess profit.

ii. When TR < TC then there exist loss.

iii. When TR = TC then there exist normal profit.

In this approach profit is maximized at thatpoint where the difference between TR and TCis maximum.


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Graphically,

O Quantity Output

T R a n

d T C

TRTC

A

Q0

B

Q2

E

Q1

D

LOSS

LOSS

MAXIMUM PROFIT

T

T1

PANEL A


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In the above figure, along x-axis we plot quantityoutput and along y-axis we plot TR and TC.

TR is the total revenue curve which is originatedfrom origin O and upward sloping from left tothe right. This is due to constant price in perfectcompetition market.

TC is the total cost curve which is inverse s-shaped, due to application of law of variableproportions.

In perfect competition market structure, profit ismaximum when the gap between TR and TC ismaximum. And it is obtained by drawing parallelline with TR curve and which is tangent to the TCcurve.

h b f h h d d h b f


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In the above figure, the shaded area shown beforepoint A is the case of loss bearing situation. WhereTC > TR. And similarly, shaded area beyond the point

B is also loss bearing situation. Where TC > TR.Hence, any level of output in this range are lossbearing.

At point A and B, TR = TC, so, this is the situation ofnormal profit. That means, OQ0 and OQ2 level ofoutput shown in the figure are the level of outputwhich provides normal profit to the producer in

perfect competition market.In the above figure, if we draw parallel line with TR

curve and which is tangent to the TC curve then, wecan get the maximum difference between TR andTC. This is situation of maximum profit.


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In the figure, we draw parallel line TT1 with TRcurve and which is tangent with TC curve atpoint E. If we extend the line from this point up-to pint D, we get the maximum gap between TRand TC which is denoted by DE, this is excessprofit of the firm.

This is the situation of equilibrium of a firm withmaximum profit DE and equilibrium level ofoutput Q1, which is shown in above figure.

The firm can earn profit in between the range ofA and B but the maximum profit earning rangeis the DE.


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Here in Panel-B, we show equilibrium ofmonopoly firm. where TR curve initiallyincreases at increasing rate, increases atdecreasing rate, reaches to its maximumpoint and finally it starts to decline as shownby TR. i.e. TC curve is bell shaped.

On the other hand, TC curve is inverse S-Shaped due to operation of law of variableproportion in the process of production.

Since, the objective of the monopolist firm isto maximize the profit. And the profit will bemaximum when the difference between TRand TC is highest.Mathematically,

i TR TC


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i.e. = TR TC

Where, = Total Profit,

TR = Total Revenue and

TC = Total Cost.

In above formula, we can see three cases;

i. When TR > TC then there exist excess profit.

ii. When TR < TC then there exist loss.

iii. When TR = TC then there exist normal profit.

The profit is maxized at the output where there isthe biggest gap or highest difference between TRand TC. It can be illustrated by the followingfigure.


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Graphically,

O Quantity Output

T R a n

d T C

TR

TC

A

Q0

B

Q2

E

Q1

D

LOSS

LOSS

MAXIMUM PROFIT

T1

PANEL B T2

2 MR MC A h f D t i i E ilib i L l


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2. MR MC Approach of Determining Equilibrium Levelof Price and Output

Marginal Revenue and Marginal Cost (MR-MC)

Approach another method of finding profitmaximizing level of output in case of perfectlycompetitive market and monopoly market structure.

In this approach following two conditions must besatisfy by the firm for equilibrium.

a. First Condition (Necessary Condition):

Marginal Revenue (MR) should be equal to the

Marginal Cost (MC), i.e. MR = MC.This means, a firm will be equilibrium in that level ofoutput where cost of production of one more unit

(MC) is equal to the revenue obtained from the saleof that unit MR .


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b. Secondary Condition ( Sufficient Condition):

Only MR = MC condition is not sufficient for the firmsequilibrium in perfect competition and monopolymarket.For the equilibrium of the firm, the sufficientcondition is, at the point of equilibrium MC curve

must cut MR curve from below, i.e. slope of MC >slope of MR.

For both perfectly competitive and monopoly marketstructure two conditions mentioned above are thenecessary and sufficient conditions. Which arecommon for both in case of MR-MC approach.

This approach simultaneously determines equilibrium

level of output and equilibrium price of a product.


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Quantity Output

M R

, M C

a n

d P r i c e

O

AR=MRP

MC

e1 e

Q1Qo

It can be explained with the help of graph, infollowing graph. Where Panel-A representsequilibrium condition of perfectly competitive

market and Panel B represents the equilibriumcondition of monopoly market.Graphically,

Panel - A


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In the above figure, along x-axis we plot quantityoutput and along y-axis we plot, MR, MC andPrice.

In the perfect competition market AR and MRand Price are constant so curve is horizontaland parallel to x-axis as shown in the figure.

First order condition is satisfied at point e andpint e1. where, MR=MC.

But sufficient condition is satisfied only at pointe (where slope of MC > slope of MR), which isequilibrium point and the equilibrium level ofoutput is OQ1 and equilibrium price OP in caseof perfectly competitive market.

o eve o ou pu s no equ r um eve o ou pu ecause


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Panel B

M R

, M C a n d

P r i c e

Quantity OutputO

AR

MR

MC

E

A

Qe

Pe

- o eve o ou pu s no equ r um eve o ou pu , ecause,at point e1 first order condition of equilibrium is satisfied (i.e.MR = MC) and second order condition is not satisfied (i.e. slopeof MC < slope of MR).


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2 Features of Perfect Competition Market:

a. Large Number of Buyers and Sellers:

There is a large number of buyers and sellers in aperfectly competitive market.

Individual consumer and individual seller can notinfluence the market price. They has nosignificant effect on total market demand.

Because, both the individual consumer and buyerare only a small unit of the whole market.

In this type of market price is assumed to befixed for both individual buyers and sellers,therefore, sellers are only price takers and output

adjusters.


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F E t d E it f th Fi


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c. Free Entry and Exit of the Firms:

In this kind of market any firm is completely free toenter into the industry and to exit from the industry.

If there is abnormal profit in the industry in short-run, then new firms inter into the industry and ifthere is loss then the firm exit form the industry.

Hence, there is always normal profit in the industryin the long-run.

d. Perfect Knowledge About the Market:

In this kind of market, all buyers have perfectknowledge about the current and future conditionof the market and sellers have perfect knowledgeabout prices of goods and prices of the factors ofproduction.


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e. Perfect Mobility of the Factors of Production:

All the factors of production are free to enter intoand exit from the industry. There is no monopolypower on raw materials, any factors of productionand labor.

This means if a laborer get higher wages in anyother factory then he is free to quit the existingfactory for higher wage in another factory.

f. No Transportation Cost:

In the perfectly competitive market there is nocosts of transportation. If transportation cost isimposed then the prices will not be uniform.

Which violates the assumption of constant price.


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g. No Government Intervention/ Regulation:

In the free market economy there is nogovernment intervention. It means governmentshould not charge tariffs, subsidies, taxes andother barriers in the market.

Two market forces demand and supply determinesthe equilibrium price and output in the market.Thus, perfectly competitive market is the freegame of demand and supply. Hence, government

intervention should be prohibited.i. Profit Maximization Goal:

In this type of market, all firms in the industry

have the objective of profit maximization.

f


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Price and Output Determination Under PerfectCompetition

Interaction of market demand and market supplydetermines the equilibrium level of price andoutput under the perfect competition market.

Equality of demand and supply gives an

equilibrium position.That is when two market forces demand andsupply equals to each other at that time

equilibrium level of output and equilibrium level ofprice are simultaneously determined.

These two market forces can be explained as

follows:

A Demand:


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A. Demand:According to the law of demand, other thingsremaining the same there exist inverse

relationship between price and quantity demand.Hence, demand curve is downward sloping.

But the degree of change in quantity demand due

to change in price depends on elasticity ofdemand.

B. Supply:

According to the law of supply, other thingsremaining the same there exist positiverelationship between price and quantity supply.

But the degree of change in quantity supply due tochange in price depends on elasticity of supply.

Th f d i i f i d


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The process of determination of price and outputunder perfect competition market can be explainedwith the help of following table,

Demand & Supply SchedulePrice(Rs.)

Quantity Demanded(Qd)

Quantity Supplied(Qs)

Status Effect on Price

2 50 10 Qd>Qs Rise

4 40 20 Qd>Qs Rise

6 30 30 Qd=Qs Stable

8 20 40 Qd


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The price and output determination process underperfectly competitive market can be illustrated withthe help of following graph,

Graphically:

O Quantity of Goods

P r i c e

D1

D

S

S1

E Qd=Qs

Qe

Pe

P1

Excess SupplyQs>Qd

A B

Po

Excess DemandQd>Qs

C D

Alternative Method


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Alternative Method

Short Run Equilibrium of the Firm and Industry

In Case of Perfectly Competitive Market

Short-run refers to that period of time where aproducer can not change the amount of fixed inputs.

A firm can increase level of output by changing

amount of variable factors of production only.In short run a firm bears two types of cost i.e. fixedand variable cost. Fixed cost remains constant withevery increase in level of output and the variable costvaries with every increase in level of output.

For the equilibrium of a perfectly competitive firm,according to MR-MC Approach, following two

conditions must be fulfilled

N C diti MR MC


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1. Necessary Condition: MR = MC

2. Sufficient Condition: Slope of MC Curve > Slope ofMR Curve. i.e. MC Curve must cut MR curve frombelow.

When these two conditions are fulfilled, the firm issupposed to be in equilibrium condition. In short-run

equilibrium, the firm and industry under perfectcompetition may face following three situations:

a. Equilibrium with Supernormal Profit. (AR>AC).

b. Equilibrium with Normal Profit. (AR = AC).c. Equilibrium Incurring Losses.(AR


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Graphically,

Fig.A:Equilibrium of Industry

Fig.B: Firm-A

Equilibrium of a firm withsupernormal Profit

OQuantity Quantity

O

P r i c e

Price

S1

S D1

D

E

Qe

PeP

AR=MR=P

SMC

E1

Q1

SAC

AB

AR>SACSupernormal

Profit


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LONG RUN EQUILIBRIUM OF PERFECT COMPETITION FIRM


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LONG RUN EQUILIBRIUM OF PERFECT COMPETITION FIRM

In long-run all factors of productions are assumed to bevariable. Hence, in long-run firms have enough time to

adjust their outputs by changing the factors ofproduction.

In long-run cost is not divided into variable cost andfixed cost. Due to which all the firms have identical costcurves.

Entry and exit of new firms are allowed in the long-run.If the profit level is high, then the new firms enter into

the industry. If profit level is low or loss the existingfirms quit the industry.

When all competitive firms earn normal profit, thenthere is no tendency for the entry of new firms into theindustry and exit of existing firms from the industry.

That situation is known as long-run equilibrium of


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That situation is known as long run equilibrium ofthe industry.

In long-run also, following two conditions most be

fulfilled to determine the equilibrium of the firms,i. MR = MC (necessary condition)

ii. Slope of MC > Slope of MR. ( sufficient

Condition.)(i.e. MC curve must cut MR curve from below)

When all firms under the industry are operating at

normal profit, industry is said to be in equilibrium.Where following conditions must be fulfilled by theindustry to be in equilibrium.

1. All the firms under the industry should be inequilibrium.

2 All th fi h ld b ti g t l


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2. All the firms should be operating at normalprofit ( i.e. AR = P = AC ) so that there is notendency of the firms to enter or quit theindustry.

3. The quantity demand and quantity supplied

of the product should be equal. (i.e. D = S ).Long-run equilibrium of the industry can beexplained with the help of following table.

Where,LMC = Long-run Marginal Cost

LAC = Long-run Average Cost

Graphically


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Graphically,

Fig.A:Equilibrium of Industry

Fig.B:

Long-run Equilibrium of a firm

OQuantity Quantity

O

P r i c e

Price

S1

S D1

D

E

Qe

PeP

AR=MR=P

LMC

Q1

LAC

E

AR=LACNormal

Profit

PRICE AND OUTPUT DETERMINATION


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PRICE AND OUTPUT DETERMINATIONUNDER MONOPOLY MARKET

1. Concept of Monopoly

2. Features of Monopoly

3. Determination of Price and Output UnderMonopoly.

A) Short-Run Equilibrium of Monopoly

B) Long-Run Equilibrium of Monopoly

1. Concept of Monopoly:


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1. Concept of Monopoly:The term Monopoly has been derived from the twoGreek words 'Mono' and 'Poly'. Where mono means

single and poly means seller. It is opposite to theperfect competition.

Thus, monopoly is a market structure where there issingle seller of a product having no close substitutewith large number of buyers.

Single firm it self is industry and there is barrier toentry new firms into the industry.

In this type of market structure, a firm have fullcontrol over the price and quantity supply of theproduct. That means monopoly firm is price maker. Itsets price of the product itself. Monopolist is like aking without crown.

Hence, the demand curve of monopoly firm is


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Hence, the demand curve of monopoly firm isdownward sloping from left to the right. This signifiesthat, monopoly can sale more goods at lower price

and vice-versa.2. Features of Monopoly:

The main features of the monopoly marketstructures are as follows:

1. Single seller and many buyers.

2. The goods produced by single seller have no closesubstitutes.

3. Barriers to entry the new firms into the industry.

4. A firms itself is industry.

5. Monopoly firm is price maker. It sets the price ofroduct itself.


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Equilibrium Condition:


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q

a. MC = MR

b. MC curve must cut MR curve from below. i.e. the

slope of MC > the slope of MR.A. Short Run Equilibrium of Monopoly Firm:

In short-run equilibrium analysis generally we can see

three cases,a. Abnormal Profit (AR > AC)

b. Normal Profit (AR = AC)

c. Losses (AR < AC)In short-run equilibrium, it does not mean that a firmmakes abnormal profits. Whether a firm makesabnormal profit or normal profit or incurs lossdepends upon the level of AC.

Thus it is important to analyze the above


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Thus, it is important to analyze the abovementioned three cases as per the level of AC withthe help of following graphs.

Graphically,

Output

C ,

R ,

P

O

AR

MR

Case a : Equilibrium of a firmwith abnormal profit (AR>AC)MC

E

Qe

APe

AC

BC

Abnormal Pofit

Case b : Equilibrium of a firm with normal profit


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Case b : Equilibrium of a firm with normal profit(AR = AC)

Output

C ,

R ,

P

O

AR

MR

MC

E

Qe

APe

AC

Normal Pofit

Case c : Equilibrium of a firm incurring loss


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q g(AR


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Thus, we conclude that in short run equilibrium of afirm, the level of AC determines whether a firm bearslosses or enjoys abnormal profit or just stay with normal

profit at equilibrium.In this way at equilibrium price Pe, a firm sells Qe levelof equilibrium output.

A firm in monopoly bears losses in rare conditions only,i.e. at the time of depression and initial stage ofproduction. Otherwise it enjoys with abnormal ornormal profit.

B. Long run Equilibrium of Monopoly Firm:A monopolist firm in the long-run always enjoysabnormal profit (AR>AC) due to strict barriers to entryof new firms and there is enough time for a firm toadjust its factors of production and level of output.

Long-run equilibrium of a monopolist firm can be


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Long run equilibrium of a monopolist firm can beexplained with the help of following graph:

Graphically,

Output

C ,

R ,

P

O

AR

MR

Long-Run Equilibrium of a firm

LMC

E

Qe

APe

LAC

BC

Abnormal Pofit


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theory of price and output determination

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