Introduction

Price is arrived at by the interaction between demand and supply. Price is dependent upon the characteristics of both these fundamental components of a market. Demand and supply represent the willingness of consumers and producers to engage in buying and selling. An exchange of a product takes place when buyers and sellers can agree upon a price.

 

Equilibrium Price

When a product exchange occurs, the agreed upon price is called an "equilibrium" price, or a "market clearing" price. Graphically, this price occurs at the intersection of demand and supply as presented in Figure 1. In Figure

1, both buyers and sellers are willing to exchange the quantity Q at the price P. At this point, supply and demand are in balance.

 

Price determination depends equally on demand and supply. It is truly a balance of the two market components. To see why the balance must occur, examine what happens when there is no balance, for example when market price is below that is shown as P in Figure 1. At any price below P, the quantity demanded is greater than the quantity supplied. In such a situation, consumers would be clamoring for a product that producers would not be willing to supply; a shortage would exist. In this event, consumers would choose to pay a higher price in order

to get the product they want, while producers would be encouraged by a higher price to bring more of the product onto the market.

 

 The end result is a rise in price, to P, where supply and demand are in balance. Similarly, if a price above P were chosen arbitrarily the market would be in surplus, too much supply relative to demand. If that were to happen, producers would be willing to take a lower price in order to sell, and consumers would be induced by lower prices to increase their purchases. Only when the price falls would balance be restored.

A market price is not necessarily a fair price, it is merely an outcome. It does not guarantee total satisfaction on the part of buyer and seller. Typically some assumptions about the behaviour of buyers and sellers are made, which add a sense of reason to a market price. For example, buyers are expected to be self-interested and, although they may not have perfect knowledge, at least they will try to look out for their own interests. Meanwhile, sellers are considered to be profit maximizers. This assumption limits their willingness to sell to within a price range, high to low, where they can stay in business.

What is the difference between changes in demand’ and increase/decrease in demand

Changes in demand	Increase in Demand	Decrease in Demand
First, a demand (or supply) determinant changes.	Change in Factors Other Than Price   1. Increase in Taste increases the demand curve.	Change in Factors Other Than Price   1. Decrease in Taste decreases the demand curve.
Second, this determinant change causes the demand curve (or supply curve) to shift.	2. Increase in population increases the demand curve.	2. Decrease in population decreases the demand curve.
Third, the change in demand (or supply) causes either a   shortage or a  surplus imbalance in the market. The market is in a temporary state of disequilibrium	3. Increase in income in income increases demand if a normal good.	3. Increase in income decreases demand if an inferior good.
Fourth, the shortage and surplus imbalance causes the price of the good to change.	4. Decrease in income increases demand if an inferior good.	4. Decrease in income decreases income if a normal good.
Fifth, the change in price causes a change in quantity demanded (and supplied).	5. Increase in price of substitute (Pepsi) increases demand for good (coke).	5. Decrease in price of substitute (Pepsi) decreases demand for good (coke).
·Sixth, the change in quantity demanded (and supplied) eliminates the shortage or surplus and restores market equilibrium.	6. Decrease in price of complement (beer) increases demand for good (pizza).	6. Increase in price of complement (beer) decreases demand for good (pizza).

What relationship does the price elasticity of demand bear with marginal revenue and average revenue

Relationship between Average Revenue, Marginal Revenue and Price Elasticity of Demand

There is a crucial relationship between the AR, MR and elasticity of demand, which is used extensively in the theory of pricing. The relationship is expressed in the form of formula,

But, AQ is marginal revenue and SQ is average revenue corresponding to point ‘B’ at OQ level of output. Hence, equation (2.9) can be written as

The above relationship can be utilised to find out the marginal revenue corresponding to the average revenue at any given level of quantity sold, provided the price elasticity of demand is known.

The relation between AR, MR and elasticity of demand (e) can now be written as

With the help of the above formula, it is possible to find MR, given AR (price) and elasticity of demand. For example, for AR = 10 and e = 2,

Thus, for e = I, MR = 0. This is very useful relationship and should be noted carefully. Here, total revenue outlay is not affected by change in price, as discussed under ‘Total Outlay Method’ in Chapter 2 on Elasticity of Demand.

It can also be shown that at every point on the demand curve, where elasticity is greater than unity, MR is positive (but, less than AR). Further, at every point on the demand curve where elasticity is less than unity, MR is negative. This can be verified by substituting the value of elasticity in equation (14.9). An increase in the price will result in an increase and a decrease of the total revenue in these two cases respectively and vice-versa. AR, being price is always positive.