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FBM 1101 PRINCIPLES OF ECONOMICS

Lec 7 MARKET AND PRICE DETERMINATION UNDER DIFFERENT MARKET SITUATION

What is a Market?

In economics, markets are a central focus of analysis, so economists try to be as clear


as possible about what they mean when they refer to a market. The individual economic
units are grouped into two broad groups according to function— buyers and sellers. Buyers
include consumers, who purchase goods and services, and firms, which buy labor, capital,
and raw materials that they use to produce goods and services. Sellers include firms, which
sell their goods and services; workers, who sell their labor services; and resource owners,
who rent land or sell mineral resources to firms.
Together, buyers and sellers interact to form markets. A market is the collection of
buyers and sellers that, through their actual or potential interactions, determine the price of
a product or set of products.
Market refers to an arrangement where buyers and sellers come into close contact
with each other for the purpose of exchanging their goods and services. A market need not
be a place or a locality where the commodities in question are exchanged but there has to
be a contact between the buyers and sellers so that goods and services are bought and sold
at an agreed price.
Communication between the buyers and sells can also take place through telephone,
fax, telegram, internet, etc. In such cases too, a market is said to exist.
An industry is a collection of firms that sell the same or closely related products. In
effect, an industry is the supply side of the market.
Essential features of a market:
 Two parties in a market i.e., buyers and sellers
 Contact between them (either directly or indirectly)
 A product which is demanded & sold
 Price of commodity is determined through the interaction between buyers and
sellers.
 Willingness & ability to buy & sell

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Classification of Markets
Market is classified into various types based on the characteristic features. They are
classified on the basis of:
 Area: Local, regional, national and international market
 Time: Very short period, short period, long period, very long period market
 Nature of goods: Commodity and capital market
 Nature of Transaction: Spot market, forward market and futures market
 Volume of business: Whole sale market & retail market
 Regulation: Regulated market & unregulated market
 Market structure/ Competition: Perfect market and imperfect market

Market Structure
It refers to the size and design of the market. It relates to those organizational
characteristics of a market which influence the nature of competition and pricing and affect
the conduct of business firms.
Based on the degree of competition or market structure, markets are classified as
perfect and imperfect market
Perfect market/competition: A market is said to be perfect when all the potential sellers and
buyers are promptly aware of the prices at which transaction take place and all the offers
made by other sellers, and buyers, and when any buyer can purchase from any seller and
conversely. Under such a condition, the price of a commodity will tend to be the all over the
market.
Imperfect market/competition: A market is said to be imperfect when some buyers or
sellers or both are not aware of the offers being made by others. Different prices prevail for
the same commodity at the same time i.e, the individual sellers have some degree of control
over the price of the products.
Imperfect markets include
 Monopolistic competition
 Pure Oligopoly
 Differentiated oligopoly
 Monopoly

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DETERMINATION OF MARKET PRICE- Market Equilibrium

The price of a commodity in a market is determined by the interaction of the market


demand and supply forces.
Market equilibrium refers to a condition where a market price is established through
competition such that the amount of goods or services bought by buyers is equal to the
amount of goods or services produced by sellers.
Thus, the interaction of supply and demand ultimately determines a competitive
price, Pe such that there is neither a shortage nor a surplus of the good. This price is called
the equilibrium price and the corresponding quantity, Qe is called the equilibrium quantity
for the competitive market. Once this price and quantity are realized, the market forces of
supply and demand are balanced; there is no tendency for prices either to rise or to fall.

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Excess Supply

In this diagram the equilibrium price is P* and the quantity supplied Q*. However, the
prices have been increased to P2. As the price has increased it will lead to more suppliers
entering the market and supply increasing to Qs. At the same time, an increase in price to P2
will lead to a fall in demand (as per the law of demand) i.e. Qd. This will create an excess
supply situation. Now the suppliers will find it difficult to sell their goods and they will have
to reduce their price to attract more consumers. This will go on till the price again reaches its
initial level i.e. P*.
Excess demand

Take the situation when prices have been artificially reduced from P* to P1. This leads
to a fall in supply from Q* to Qs (as per law of supply). As the prices fall from P* to P1, people
can afford to buy more of that good and demand increase from Q* to Qd. Again an excess

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demand situation is created. In order to get the most out of this situation the suppliers will
start increasing their price. On the other hand demand will start falling as the prices
increase. This will all continue till the prices settle at equilibrium price i.e. P*.

PRICE DETERMINATION UNDER PERFECT COMPETITION


Features of perfect competition:
 There are many buyers and sellers in the market, each of which is “small” relative to
the market.
 Each firm in the market produces homogeneous products which act as perfect
substitutes.
 Buyers and sellers have perfect information- buyers and sellers are fully aware of the
prices that are being offered and accepted.
 There is free entry into and exit from the market.
 The commodity or goods are sold at a uniform price throughout the market at any
given point of time. All the firms acting in the market are price takers.

In a perfectly competitive market, all firms charge the same price for the good, and
this price is determined by the interaction of all buyers and sellers in the market. Thus Pe is
the equilibrium price charged by all the firms in the market and is determined by the
intersection of the market supply and demand curves. If a firm sells the product at a price
higher than Pe, then the consumer’s demand for that firm’s product decreases. If the firm
decides to sell the product at a price lower than Pe, then the firm would be incurring a loss.
So every firm in the market will be selling the goods at Pe and the only decision left with
them is how much quantity to be sold in order to gain profit.

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Under perfect competition, the demand for an individual firm’s product is the market
price of output, which we denote P. The demand curve for a competitive firm’s product is a
horizontal line at the market price. This price is the competitive firm’s marginal revenue.
Df = Pe = MR
The demand curve for an individual firm in perfect competition is perfectly elastic.

Short-Run Output Decisions under perfect competition


To maximize profits in the short run, the manager keeping the given fixed inputs (and
thus the fixed costs) and determine how much output to be produced given the variable
inputs that are within his or her control.

Suppose if the market price is given by Pe. The price Pe is the market equilibrium price
determined by the interaction between the demand and supply curves of the market. This
price intersects the marginal cost curve at an output of Q* as shown in the figure above. At

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Q*, MR becomes equal to MC. For any firm, the point where MR = MC, it gives the profit
maximization level of output. Thus, Q* represents the profit-maximizing level of output. For
outputs below Q*, price exceeds marginal cost. This implies that by expanding output, the
firm can sell additional units at a price that exceeds the cost of producing the additional
units. (i.e, MR starts increasing as the units of output sold increases). At outputs below Q*,
MR is greater than MC, thereby getting positive profit. As the quantity of output increases,
MR starts increasing and at the output level Q*, MR gets maximum and thus obtains
maximum profit. (Fig 1)
Thus, a profit-maximizing firm will not choose to produce output levels below Q*.
Similarly, output levels above Q* correspond to the situation in which marginal cost exceeds
price. The profit is negative at output levels above Q*. Thus, Q* is the profit-maximizing level
of output. The firm will be earning supernormal profits on short run. The shaded rectangle
ABCD represents the maximum profits of the firm.
Note: Suppose the market price, Pe, lies below the average total cost curve but above the
average variable cost curve. At the Q* level of output, the firm will be incurring a loss equal
to the area of the rectangle ABCD (Figure 2).
This loss is due to the fact that the firm is unable to meet its fixed costs but is able to
meet its variable costs. Thus, the firm should continue to produce in the short run, even
though it is incurring losses.
Fig 2

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Now suppose the market price is so low that it lies below the average variable cost.
In this case, the firm is unable to meet both the fixed and variable costs and hence decides
to shut down.
Long Run Output decision
As firms in short run starts earning super normal profits, in the long run additional
firms will enter the industry in an attempt to reap some of those profits. As more firms enter
the industry, the industry supply curve shifts to the right, which lowers the equilibrium
market price. This shifts down the demand curve for an individual firm’s product, which in
turn lowers its profits.

If firms in a competitive industry sustain short-run losses, in the long run they will exit
the industry. As firms exit the industry, the market supply curve shifts upward thus
increasing the market price. This, in turn, shifts up the demand curve for an individual firm’s
product, which increases the profits of the firms remaining in the industry. This cycle repeats
itself. On long run, all firms in the industry will be earning normal profits only.
Long run equilibrium of the industry: A perfectly competitive industry is in long run
equilibrium when (i) all the firms are earning normal profits only i.e. all the firms are in
equilibrium (ii) there is no further entry or exit from the market.

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At the price of Pe, each firm receives just enough to cover the average costs of
production (AC is used because in the long run there is no distinction between fixed and
variable costs) i.e profit is zero.

PRICE DETERMINATION UNDER MONOPOLY


Features:
 Single seller in the market
 There are no close substitutes
 No competition in the market- greater market power i.e, firm can fix the price of the
product in the market ( Price fixers)
 There exists restriction for free entry and exist of firms ( i.e, Entry barriers exist)
 Both market demand curve and the demand curve for monopolist’s product remains
the same.

The demand curve of a monopoly


market is given by Df. Since all
consumers in the market demand the
good from the monopolist, the market
demand curve, DM. Hence the demand

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curve of the firm and market demand curve remains the same (Df = DM).
In a monopoly market, the monopolist is free to charge any price for the product. If the
monopolist sets the relatively low price of P1, the quantity demanded by consumers is Q1.
The monopolist can set a higher price of P0, but there will be a lower quantity demanded of
Q0 at that price.
Profit maximization under Monopoly
A monopolist has to determine not only his output but also the price of his product.
Since he faces a downward sloping demand curve, if he increases the price of his product,
his sales will go down. On the other hand, if he wants to improve his sales volume, he will
have to be content with lower price. He will try to reach that level of output at which profits
are maximum, i.e, he will try to attain the equilibrium.
Profit maximization occurs at the output level where MC = MR.
In monopolist, MR curve lies below the demand curve.

The marginal revenue curve intersects the marginal cost curve when QM units are
produced, so the profit-maximizing level of output is QM. The maximum price per unit that
consumers are willing to pay for QM units is PM, so the profit-maximizing price is PM.
Monopoly profits are given by the shaded rectangle in the figure.
Given the level of output, QM, that maximizes profits, the monopoly price is the price
on the demand curve corresponding to the QM units produced: PM = P (QM).

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To sum up, in a monopoly market, profit maximization output level occurs at the
point where MR = MC. Profit maximization price is the price on the demand curve
corresponding to the profit maximization output level. The firm incurs super normal profit in
short run.
On long run also, a monopolist firm enjoys the super normal profit as there exist
strong entry barriers in the monopoly market. The entry barriers may be due to the
economies of scale, patents or some legal restrictions that is exclusively enjoyed by the
monopolist firm.

PRICE DETERMINATION UNDER MONOPOLISTIC COMPETITION


A market structure that lies between the extremes of monopoly and perfect
competition is monopolistic competition. This market structure exhibits some characteristics
present in both perfect competition and monopoly. An industry is monopolistically
competitive if:
 There are many buyers and sellers.
 Each firm in the industry produces a differentiated product. The products are close,
but not perfect substitutes.
 There is free entry into and exit from the industry.
As each firm in a monopolistic market sells slightly differentiated products, an
increase in the price of the product of one firm may result in consumers substituting it with
another firm’s product been sold at a lower price within the market. Hence the firms under
monopolistic competition experiences a small market power and can decide the price of the
product.
The fact that the products are not perfect substitutes in a monopolistically
competitive industry thus implies that each firm faces a downward-sloping demand curve
for its product. To sell more of its product, the firm must lower the price. In this sense, the
demand curve facing a monopolistically competitive firm looks more like the demand for a
monopolist’s product.

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Profit Maximization
The determination of the profit-maximizing price and output under monopolistic
competition is precisely the same as for a firm operating under monopoly. Here the demand
curve is downward sloping and the marginal revenue curve lies below it, as in case of
monopoly. To maximize profits, the monopolistically competitive firm produces where
marginal revenue equals marginal cost. This output is given by Q* in the Figure. The profit-
maximizing price is the maximum price consumers are willing to pay for Q* units of the
firm’s output. The firm’s profits are given by the shaded region.
To conclude,
The profit-maximizing output, Q*, is such that MR (Q*) = MC (Q*) &
The profit-maximizing price is P*= P (Q*)

The basic principles of profit maximization are the same under monopolistic
competition and monopoly. But the difference arises in the case of demand curves that are
being chosen for analyzing the profit maximization output and price. The demand and
marginal revenue curves used to determine the monopolistically competitive firm’s profit-
maximizing output and price are based not on the market demand for the product but on
the demand for the individual firm’s product. The demand curve facing a monopolist, in
contrast, is the market demand curve.
Thus in the short run supernormal profits are possible.

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Long run equilibrium under monopolistic competition
Because there is free entry into monopolistically competitive markets, if firms earn
short-run profits in a monopolistically competitive industry, additional firms will enter the
industry in the long run to capture some of those profits. Similarly, if existing firms incur
losses, in the long run some firms will exit the industry.
Suppose a monopolistically competitive firm sells its product and faces a downward
sloping demand curve. In short run, this demand curve lies above the ATC curve; the firm is
earning positive economic profits. This, of course, lures more firms into the industry. As
additional firms enter, the demand for this firm’s product will decrease because some
consumers will substitute toward the new products offered by the entering firms. Entry
continues until the demand curve decreases and becomes just tangential to the firm’s
average cost curve. At this point, firms in the industry are earning normal profits, and there
is no incentive for additional firms to enter the industry.

The long-run equilibrium in a monopolistically competitive industry is characterized


by the situation where each firm earns normal profits but charges a price that exceeds the
marginal cost of producing the good.

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