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Managerial Economics

Lecture 3: Market Equilibrium

We have till now only looked at aspects concerning the household, namely how they decide how
much to earn, how much to save, and that they decide to spend on. In all these decisions, price
was an important variable, but that was given from outside the system. We now concentrate on
how prices are determined within the system. That depends on not only the decisions of the
household, but also that of the firm, so we need to look into firm behavior. A firm’s objective is
to maximize profits, which constitute revenues less costs. We assume that firms are given input
as well as output prices, and it has to decide on how much of output to produce given input as
well as output prices. The other issue of interest is how a supplier would respond to a rise in
output prices.

To look further into this problem it will be helpful to define a few concepts, namely that of
marginal revenue and marginal costs. Marginal revenue refers to the increase in total revenue
when an extra unit of output is produced and sold. Marginal cost refers to the increase in total
costs when an extra unit of a good is produced. Therefore, an extra unit is produced if and only if
the marginal revenue exceeds or is equal to the marginal costs. If price is given from outside, the
extra revenue obtained from selling an extra unit is the price, and at the profit maximizing
output, price must equal marginal cost. To illustrate the same, let us look at Table 14. As we can
see costs are increasing at an increasing rate, when price is 4, the profit maximizing output is 2,
at which marginal revenue equals marginal cost. Therefore as output price increases to 5, the
profit maximizing output is 3. Therefore if there are 10 such identical suppliers, the market
supply will be 20 at an output price of 4 and 30 at an output price of 5.

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Table 14

Thus if producers P and Q are suppliers of food, the derivation of the market supplier curve will
be given as in Figure 33.

Figure 33

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It should be noted that if fertilizer prices were to fall, profit maximizing output would increase
the firm supply as well as the market supply would shift to the right. Now that we have got both
the market demand curve and the market supply curve, juxtaposing both in the same diagram
gives us the equilibrium price, the price at which both curves intersect, this is the price which
prevails in the market and the quantity that is traded in the market. The same is shown in Figure
34.

Figure 34

We will therefore have such equilibrium prices in food, clothing and all other markets. Let us
assume a closed village economy which produces and consumes all its goods. If there happens to
be a drought in the village, the supply curve for food shifts to the left. Farmer’s incomes are
affected, not only that they demand less of clothing, so the weaves incomes are also affected, for
which the demand for food will also fall. What is clear however, is that the equilibrium quantity
of food traded in the market falls, food prices may rise or fall depending on the relative shift of
demand and supply curves as in Figure 35. With a change in food prices, demand for clothing
also gets affected, which also changes the equilibrium in the clothing market. What is seen is a
shock in one market spreads to other markets as well in a closed economy. If the weaver had
access to outside markets, he would not be that much affected by the shock. However,
completely specializing in export markets of one country also has its risks; ones income is
completely dependent on the economic conditions of that country. So it is best to diversify by
selling in different markets.

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Figure 35

One can use the simple economics of demand and supply to analyze many real life situations.
Siwan Anderson wrote a very interesting paper on the economics of dowry and the bride price.
According to him, bride price is more common in places with heavy involvement of women in
agriculture, whereas dowry is more common in places where women’s outside role is limited.
Bride price is usually dependent upon the expected number of children a woman would bear.
Dowry was seen as a means to attract a good groom; men who were more qualified would
command a high dowry. However, what is surprising that in South Asia, despite the skewed sex
ratio with many more men than women, there is more of evidence of dowry rather than the bride
price. This explanation given is in south Asia there is usually a difference in age between the
bride and the groom, and if there is population growth, it might be the case that many more
women than men enter the marriage market and we may witness dowry. Dowry is also seen as an
inheritance payment, women receive dowry and men receive bequests.

Economists would always recommend that in most cases there be as little interventions as
possible. Markets functioning well lead us to a set of prices and demand from households and
supply by producers at which households maximize utility subject to their budget constraint;
producers maximize profits and demand is equal to supply in all markets. If market prices are
tampered with, it leads to overuse of resources which are scarce and underuse of resources which
are abundant.

• There are many instances when free market prices are tampered with. The rupee was
overvalued vis a vis the dollar, so that importers had to pay less to import machinery to

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help in the country’s industrialization. However, we ended up choosing capital intensive
techniques of production instead of labor intensive ones, and so ended up with a lot of
unemployment. A lot of water and electricity subsidies to farmers result in them choosing
crops which require lots of water, and not suited to the climatic condition of that place.
Example: sugarcane in Maharashtra and rice in Punjab. Taxes also distort the relative
prices between different goods consumed. For example taxes distort the relative choice
between consumption and leisure. Let there be an electrician and a carpenter, the
electrician does his own job in 12 hours and a carpenters job in 20 hours. A carpenter
does his own job in 12 hours and a electrician’s job in 20 hours. The wage rate for both is
10 units an hour. If both need each other, then they would work for 12 hours to pay for
the others services. If however a 50% income tax were imposed, the carpenter would
prefer to the electrician’s job himself, rather than hire a plumber since that would mean
working for 24 instead of 20 hours and vice versa.

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