Introductory Microeconomics Chapter 4 The Theory Of The Firm Under Perfect Competition

Broadly the term market refers to a structure in which buyers and sellers of the commodity interact with each other for making transactions. It is not essential that the buyers and sellers should assemble at one particular place for making transactions. The important thing is that they should be in contact with each other through any means of communication such as letters, telephones, telegrams, fax, internet etc. As a result of the contact/competition, there is tendency to one price of same good to prevail in the market.

Simply put, market is any area where buyers and sellers of a commodity interact with each other to affect purchase and sale of a commodity.

Thus, essential ingredients of a market are: (i) Commodity or service which is bought and sold, (ii) Buyers and sellers to affect transaction. (iii) Close contact among buyers and sellers. (iv) Area where there is communication or competition among buyers and sellers is spread over. Accordingly a commodity may have a local market, regional market, national market or an international market.

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MR_n = T_Rn - TR_n-1
In other words for a price taking firm, marginal revenue equals market price.

The following three conditions must hold in the short-run.

(i)    Market price (P) is equal to marginal cost (P = MC).

(ii)    Marginal cost is non-decreasing and

(iii)    In short-run market price (P) must be greater than or equal to average cost. However in the long-run market price (P) must be greater than or equal to average variable cost.

P ≥ AVC

Features of Perfect Competition (or Perfect Market)

Although there are several features as stated below but the first three are key features of perfect competition.

(i)    Very large number of buyers and sellers. The number of buyers and sellers is so large that none of them can influence the prevailing price in the market. Each buyer and seller buys or sells a very insignificant proportion of total supply of the commodity in the market. It indicates ineffectiveness of a seller or a buyer in influencing the price. In fact price of a commodity is determined by interaction of market demand and market supply (supply of all the firms) in the whole industry for which all sellers and buyers together are responsible. But once the price is determined by the industry, each firm and buyer has to accept it.

Implication of 'large number of sellers in the market' is that share of each seller in total market supply is so small that no single seller can influence the price. Hence a firm has to sell the product at the price given (determined) by the industry. It is because of this position that each firm is said to be price-taker in perfect competition. Similarly large number of buyers has the same implication, i.e., buyer's share in the total market demand is so small that no buyer on his own can influence the price. So buyer also becomes simply a price-taker.

(ii)    Homogeneous product. Products sold in the perfect market are homogeneous, i.e., they are identical in all respects like quality, colour, size, weight, design etc. They are perfect substitutes of one another. The products sold by different firms in the market are equal in the eyes of the buyers. The buyers treat products of all the firms in the industry as identical and therefore, they are willing to pay only the same price. The product being homogeneous, no individual seller can charge higher price otherwise he is liable to lose his customers. This ensures uniform price in the market. As such cross elasticity of demand and such products is infinite.

Implication of product being homogeneous is that all firms have to charge the same price for the product. Otherwise no one will buy from the firm which charges a higher price for the same item.

(iii)    Free entry and exit of firms. There is free entry of new firms and exit of existing firms. There are no artificial or government barriers in way of new firm to enter the industry. Similarly there is no barrier in the way of firm which wants to leave the industry. New firms induced by large profits can enter the industry whereas losses make the inefficient firms to leave the industry. What are the effects of free entry and exit? In case of abnormal profits (also called positive profit) at the profit maximising level of output, new firms will be attracted to the industry. This will lead to an increase in supply (i.e., supply curve will shift rightward) leading to fall in price and profit. Thus, entry process of firms will continue till there are no abnormal profits. On the contrary if there are losses due to low price, some firms will quit the industry leading to fall in supply (i.e., supply curve will shift leftward) which in turn leads to rise in market prices. Losses fall and continue to fall till they are wiped out and each firm in the industry is earning zero economic profit/normal profit. Hence free entry and exit imply zero abnormal profit.

Implication of free entry and exit is that no firm can earn above normal profit in the long run (i.e., firms earn zero abnormal profit). In short, each firm earns just normal profit (i.e. minimum profit necessary to remain in business).

(iv)    Perfect knowledge about market and technology. Perfect knowledge means that both the buyers and sellers have full knowledge about the prices and costs prevailing in the different parts of the market. All firms have equal access to technology and inputs resulting in the same per unit cost of production.

Implication of perfect knowledge. No firm is in a position to charge a different price and no buyer will pay a higher price. As a result uniform price prevails. Since there is uniform price and uniform cost, all firms earn uniform profits because profit equals price-cost.

(v)    Perfect mobility. There is perfect mobility of goods and factors of production without any hindrance or obstruction. The factors are free to enter an industry if considered profitable and leave the industry when remuneration is inadequate.

(vi)    Absence of transport cost. In perfect competition, it is assumed that there is no transport cost for consumers who may buy from any firm. This ensures existence of a single uniform price of the product.

(vii)    Demand (AR) curve is perfectly elastic and parallel to X-axis. (For detail see Q. 4.4.)

(viii)    Firm is the price-taker and industry is the price maker under perfect competition market. In such a situation all the firms earn uniform profit as there is uniform price and uniform cost of all the firms.
The firm is called price taker when it has to adopt the price determined by market demand and market supply. 
Note. In real world, perfect competition is a myth because we hardly find such a market.

Firm. A firm is a single producing unit which produces goods and services for sale. Its main objective is to earn maximum profit.

Industry. An industry is an aggregate of all the firms producing the same product or interrelated product Alternatively, all the firms producing and selling the same or differentiated products of close substitutes are collectively known as an industry. For instance, firms manufacturing shoes will be collectively called shoe industry. Clearly a firm is a part of an industry.

Price determination. (Industry price-maker and firm price-taker). Under perfect competition, price of a commodity is determined by the equilibrium between market demand and market supply of the whole industry. So, the industry is called the price-maker. Here demand and supply represent total demand and total supply of industry. No individual firm can influence the price because its share in total supply is insignificant. Every firm has to accept the given price and adjust its level of output. It has no option but to sell the product at a price determined at industry level. If is because of this reason that firm is said to be price-taker and industry, the price-maker. This price is also called equilibrium price, because at this price quantity demanded is equal to quantity supplied. This can be illustrated with the help of the following demand and supply schedule and diagram of the industry:

According to table of the industry, price of the commodity in the industry will be determined at र 6 per unit because at this price, demand and supply are equal, i.e., 60 units each. From the above table of the firm, it is also proved that under perfect competition AR = MR, both being equal to price, i.e., र 6 per unit. In other words Price = AR = MR.

Fig. 4.1

The above table has been illustrated in Fig. 4.1. In this Figure, DD is the demand curve and SS is the supply curve. Both the curves intersect each other at point E which shows that at the price of र 6, industry demand = industry supply, i.e., 60 units. Once the price is determined by the industry, every firm in the industry has to accept the price as given and firm can sell as many units of the commodity as it wants. It is because of this position why industry is called price-maker and the firm price-taker.

AR and MR Curves in Perfect Competition.

Both AR and MR curves are a horizontal straight line parallel to x-axis as shown in fig.

As explained above, industry is the price maker and the firm price taker. Every firm has to accept the price as determined by the industry. At this price (र 6 in the schedule), a firm can sell as much as it wants to sell. This means with sale of every additional unit of the commodity, additional revenue (i.e. MR) and average revenue (AR) will be equal to price. Price = AR = MR. As a result firm's AR and MR curves will be a horizontal straight line parallel to x-axis. Since AR equals price, therefore, AR curve is also said to be price line.

Under perfect competition AR curve is parallel to x-axis because AR is equal to price and remains constant.

Meaning of Monopoly.

Simply put, monopoly is a market in which there is single producer (seller). Mono literally means one, poly implies seller and so 'monopoly' means one seller. Monopoly is a market situation where there is a single firm selling the commodity and there is no close substitute of the commodity sold by the monopolist. It is very difficult for a new firm to enter the monopoly market. Consequently a monopolist is more or less free to charge any price for his product by regulating supply. It is in this sense that seller under monopoly is said to be the price-maker and not a price-taker. Monopoly is opposite of perfectly competitive market. A monopolist's essential advantage is the absence of competitors enabling him to control his supply and thereby obtain highest possible profit. The difference between the monopoly firm and industry disappears since the firm itself constitutes industry due to non-existence of any other firm dealing in the same product. Thus monopoly firm itself is the industry. The demand curve facing a monopoly firm is negatively sloped which means that a monopolist can sell more only at a lower price. Although it is difficult to find a pure monopoly yet Delhi Vidyut Board (now privatised) which supplies electricity in Delhi can be quoted a case of monopoly. Post and Telegraph, issue of currency-notes by Reserve Bank of India are some of other examples of government monopoly

Main Features of Monopoly.

A monopoly is the opposite of perfect competition because in monopoly, there is just one firm (seller), no competition, no free entry of a new firm and no close substitute of the product. Given below are its main features.

(i)    Single seller of the commodity. There is only one seller or producer of a commodity in the market. This may be due to copyright, patent law or state monopoly. As a result, the monopoly firms has full control over the supply of the commodity. The monopolist may be an individual, a firm or a group of firms or a Government Corporation or even government itself. Naturally a monopoly firm can exploit the buyers by charging almost any price for its product because of exclusive control over supply of the product. Monopoly firm itself is the price maker and not the price taker. As compared to a single seller in the market, there can be any number of buyers of the product in the monopoly market.

(ii)    Absence of close substitute of product. A product faces competition when it has close substitutes. The product sold by the monopolist has no close substitute. Though some substitutes of the product may be available yet they are not close substitutes in the sense that such substitutes may be too costly and inconvenient to use. As a result, the consumer will have to buy the commodity from the monopolist or go without it altogether. Thus a monopolist does not face competition.

(iii)    Difficult entry of a new firm. The monopolist controls the situation in such a way that it becomes very difficult for a new firm to enter the monopoly market and compete with the monopolist by producing a homogeneous or identical product. The monopolist tries his utmost to block the entry of a new firm. This barrier can be economic, institutional or artificial in nature. As a result, a monopoly firm earns abnormal profit in the long run due to blocked entry of new firms.

(iv)    Negatively sloped demand curve. The demand curve (or AR curve) facing a monopolist is negatively sloped which indicates that a monopolist can sell more only by lowering price, i.e., price has to be reduced to sell additional units, [see Fig. 4.5(a)]. Since monopolist is the only seller in the market, therefore, the demand curve facing him is the market demand curve. Again because the monopoly firm decides the output and price itself, therefore, there is no supply curve as such under monopoly.

(v)    Price maker with constraint. Since a monopoly firm is the only seller, it has substantial influence over the price of its product by manipulating its supply. It is in this sense that a monopolist is said to be a price maker. But his influence over price is not total. Price is determined by forces of demand and supply and a monopolist controls only supply. Therefore, in monopoly as output increases/decreases, price changes in accordance with what consumers are willing to pay along the demand curve. It produces product to satisfy the entire market and thus faces the market demand curve. Unless the demand curve of the product is totally inelastic, market demand curve is said to be a constraint facing a monopoly firm. Mind, a monopolist firm can no doubt, charge any price but it cannot sell any quantity at that price. Hence demand curve is a constraint.

(vi)    Price discrimination. Unlike uniform price at which a product is sold in perfect competition, a monopolist can charge different prices for his product from different persons and in different market areas. In other words, price discrimination takes place in monopoly.

A monopoly market structure emerges due to any of the following reasons (called sources of monopoly).

(i)    Grant of Patent-rights. When a company/firm introduces a new product or new technology, it applies to the government to grant it Patent Certificate by which it gets exclusive right to produce the new product or use the new technology. Patent-rights prevent others to produce the same product or use new technology without obtaining licence from the concerned company. Thus a patent offers a kind of limited monopoly. Patent-rights are granted by the government for a certain number of years. The period for which patent-right is valid is called patent-life. Thus patent-life indicates duration for which patent-right is valid. For instance, patent certificate was granted to 'Zerox' company for copying machine invented by it thereby giving rise to monopoly. Likewise it is also a case of monopoly of an author when he has copyright of his book.

Patent-right is an exclusive right granted to a firm to produce a particular product or use a particular technology on the basis of its claim to be the discoverer of the product or the technology. It is to give official recognition to the fact that the company (firm) is the originator of the new product or technology and no one else can use its technology without obtaining licence from the company. Clearly nobody will undertake the risk of making investment in research and discovery if it does not get its fruits. In a way patent-right is a reward for undertaking risk and making investment in research. Thus motivation behind granting patent-rights is to encourage innovation, discovery and to make investment in research.

(ii)    Licensing by Government. A monopoly market emerges when government gives a firm licence, i.e., exclusive legal rights to produce a given product or service in a particular area or region. For instance, Delhi Vidyut Board — a government body — had the exclusive right to distribute electricity in Delhi. Now after privatisation, the same rights have been given to two private companies with exclusive areas to serve. Similarly till recently Videsh Sanchar Nigam Limited (VSNL) had monopoly in India to provide international telephone service.

(iii)    Forming a Cartel. Sometimes individual firms while retaining their identities, unite into a group and coordinate their outputs and pricing policy in such a way as to reap the benefits of monopoly. Such formation is called a Cartel. Thus a cartel is a business combination under which firms coordinate their output and pricing policy to reap benefits of monopoly. In the words of A.C. Pigou, 'Combination is the most important factor which leads to emergence of monopoly'. To quote an example, in 1970 some oil producing companies formed a cartel by the name of OPEC (Organisation of Petroleum Exporting Companies) which sets production quotas for member states and thereby tries to manipulate price of petroleum to derive highest possible profit. A cartel is a group of firms which jointly sets output and price so as to exercise monopoly power.

Efficiency may increase when two firms merge. How? Let us imagine that firm A and firm B merge with each other. Firm A is not efficient because of its obsolete technology and firm B is inefficient because its managerial skill is poor. In case they form a monopoly by merging themselves, efficiency will increase in the form of lower cost because it will collectively make use of better technique of production and better managerial skill.

(iv) Miscellaneous. (i) Full control by a firm over an essential raw material used in production of a commodity leads to monopoly power (ii) Certain industries like locomotives, iron and steel which require heavy investments generally attain monopoly power. (iii) Government itself forms public monopolies like Railways, Posts and Telegraph, Air Transport etc. in order to safeguard the interests of the public and promote social welfare.

(a) Under Perfect Competition MR = AR

Simply put, under perfect competition MR = AR because all goods are sold at a single (i.e. same price) price in the market. We know that under perfect competition, industry is the price maker and the firm the price taker (See Q. 4.4). Every firm has to accept the price as given (determined) by the industry (i.e. the firm is only quantity adjuster). At this price, a firm can sell any amount of its product it likes to sell. What will be its result? Clearly with sale of every additional unit of the product, additional revenue (i.e. MR) and average revenue (AR) will become equal to Price. Hence both AR and MR will be equal to each other. Thus MR = AR in perfect competition.

(b) Under Monopoly (MR < AR)

The reason is that in monopoly more units of a commodity can be sold by reducing the price of the commodity. It means as sale increases, AR falls. We know that decreasing AR (price) implies decreasing MR. [See relationship between AR and MR in Q. 3.26(a)]. MR declines at a faster rate than AR. As a result MR from successive units sold becomes lower than the price or AR. Hence under monopoly MR is less than AR. That is why graphically MR curve is below AR curve as shown in Fig. 4.2,

Fig. 4.2

Briefly put, in perfect competition AR = MR as all units of the product are sold at a single (i.e., same) price. In monopoly AR > MR as more units of the product are sold by reducing the price.

Oligopoly: It is a form of the market in which there are a few big sellers of a commodity and a large number of buyers. There is a high degree of interdependence among the sellers regarding their price and output policy.

Main features of oligopoly:

1. A few firms: There are a few sellers (more than two but not many) of the commodity and each produces a substantial portion of a total output of the industry. The number of firms is so small that each seller knows that he can influence the price by his own action and that he can provoke rival firms to react.
2. Product: Products may be homogeneous like steel and fertilisers or differentiated like cars and scooters.
3. Interdependence: There is interdependence of firms for taking decision about price and output. Since there are few firms, a change in price and output of a product by any firm is likely to influence the output and profit of rival firms whose reaction may prove counterproductive. This makes the firms mutually dependent on each other in case of decisions about price and output. For example, there is interdependence of decision about price between Pepsi and Cola. If Pepsi reduces price, Coca cola may do the same substantially.
4. Selling costs: Heavy selling and advertising costs are incurred to attract customers.
5. Price rigidity: Mostly prices are stable since no firm dares to change the price for fear of retaliatory action by rival firms. Firms generally keep price at similar levels so as to avoid a price war. They resort to other methods like an advertisement to attract customers.
6. Indeterminate demand curve: Demand curve for its product is indeterminate because no firm can be sure of the demand for its product due to unsure reactions of rivals.
7. Group Behaviour: Again group behaviour in the form of collective decisions and mutual cooperation by the firm is very common.
8. Difficult entry: Entry of new firms in the industry is difficult as in monopoly. There are barriers to entry in the form of patent rights, huge capital, crucial raw material etc. As a result, firms continue to earn supernormal profits in the long-run due to almost absence of competition.

When compared with other forms of imperfect markets, we can say that if there is only one firm it is monopoly; two firms — it is duopoly; a few firms (say 5 to 10) — it is oligopoly and a large number of firms — it is monopolistic competition. 

Distinction between Perfect Competition and Monopoly:

Distinction between Perfect Competition and Monopolistic Competition

Distinction between Monopoly and Monopolistic Competition

It should be kept in mind that the demand curve (or price line) faced by a firm for its product is nothing but AR curve of the firm. It is so because AR means price and demand curve shows a relationship between price and quantity demanded. Therefore, demand curves in different market situations are, in fact, AR curves from firm's point of view.

(i)    AR curve under perfect competition. In perfect competition, AR (as well as MR) curve is a horizontal straight line parallel to X-axis as shown in Fig. 4.7. It is constant at all levels of output. The reason is that the firm is the price taker. At the given price, the firm can sell any number of units of its commodity as it wishes which means with sale of every additional unit, additional revenue (i.e., MR) and average revenue will be equal to price. As a result AR (and MR) remains constant as proved in Q.4.4. Therefore, AR curve becomes parallel to X-axis.

Fig. 4.8

Difference. But the difference between the two curves is that AR curve under monopoly is less elastic whereas AR curve under monopolistic competition is more elastic. Its reason is that in monopoly market no close substitute of the commodity is available whereas in monopolistic competition many close substitutes of differentiated goods are available.

(iii)    AR curve under monopolistic competition. In monopolistic competition, AR curve is sloping down to the right as indicated in Fig. 4.9. Its reason is that a firm can sell more by lowering the price of its commodity. And this is what the shape of AR curve reflects, i.e., with fall in price, sale has increased. As a result, AR curve is sloping down rightward. The curve is more elastic due to availability of close substitutes.

Fig. 4.9

Non-viable industry. A situation may arise when there are prospective consumers and producers of a commodity but still it is not produced. Why? It happens when the price at which producers are ready to produce is so high that the consumers are not willing to buy even a single unit of the commodity. In other words, graphically it means that the demand curve and supply curve do not intersect each other at any positive quantity as shown in Fig. 4.11. Mind, for a non-viable industry, supply curve lies above demand curve. Demand curve lying below supply curve indicates that there is no demand for the product of suppliers because the price is too high for the consumers. As a result product will not be produced. This shows the industry (of the product) is not economically viable. For instance, presently manufacturing of Commercial Aircrafts and Copying Machines in India is not economically viable whereas they are variable goods in U.S.A. and Russia.

Thus a non-viable industry is one whose demand and supply curves do not intersect each other at any positive quantity. It is an industry in which costs are too high for any positive output to be produced. When applied to the central problem of 'what to produce', it can be safely said that the good shown in Fig. 4.11 will not be produced whereas the one shown in Fig. 4.10 will be produced. Again if demand and supply curves of a commodity intersect, it shows that production of the commodity is economically viable and equilibrium can be attained.

Fig. 4.11

Effects of Shifts in Demand and Supply on Equilibrium Price. So far we have discussed effects of change in price on demand and supply of a commodity. Now we shall study converse of it, i.e., effects of shift (change) in demand and supply on equilibrium price of a commodity. Shift in demand or supply means increase or decrease in demand or supply. Mind, graphically shift in demand means shift of demand curve. We have seen that equilibrium price is the one at which quantity demanded equals quantity supplied assuming factors other than the price to be constant. But in real world, price does not remain stable rather it moves up or down all the time because of changes in factors other than the price. Such factors responsible for change in case of demand are price of related goods, income and taste of consumers etc. and in case of supply are price of factor inputs, technological progress and excise duty rates etc. So whenever there is shift in demand or supply, new equilibrium emerges in price and quantity. We discuss below the effects of shifts (changes, i.e., increase or decrease) in demand and supply on equilibrium price and quantity under the following heads: (Remember, shifts in demand/supply means increase or decrease in demand/supply at a given price, i.e., shift occurs due to change in factors other than the price of the commodity.)

1.    Shift (change) in demand only (shift of demand curve).

2.    Shift (change) in supply only (shift of supply curve).

3.    Simultaneous shift (change) in demand and supply.

(a) Simultaneous increase in demand and supply.

(b) Simultaneous decrease in demand and suppl

Effect of leftward shift of demand curve (decrease in demand). Briefly when demand curve shifts leftward, i.e. when demand decreases, equilibrium price as well as quantity sold (i.e., supply) also fall as shown in given Fig How? It is explained with chain effects.
Decrease in demand shifts the demand curve from DD to D₂D₂ leading to short demand EF₂ at the given price OP.

Since firms will not be able to sell all what they want to sell, there will be competition among sellers leading to fall in price.

As price falls, demand starts rising (along D₂D₂) and supply starts falling (along SS) as shown by arrows in Fig. 

This change will continue till demand and supply are equal at new equilibrium point E₂.

Price falls from OP to OP₂ and supply falls from OQ to OQ₂.

Effects of simultaneous demand and supply shifts (simultaneous change in demand and supply). Although there are many possibilities but we discuss its two main possibilities. (a) Effect of simultaneous increase in demand and supply (i.e., when demand and supply curves both shift rightward), and (b) Effect of simultaneous decrease in demand and supply.

(a) Effect of simultaneous rightward shift (i.e., increase) in demand and supply. There can be following three possibilities :

(i)    When increase in supply is equal to increase in demand, equilibrium price will not change, i.e., the price will remain unaffected as shown in Fig. 4.14. In this case, since both demand and supply increase, therefore, both demand and supply curves shift to the right and since both increase in the same proportion, price remains unchanged but quantity increases from PE to PE₁.

Fig. 4.14

(ii)    When increase in supply is less than increase in demand, new equilibrium price will rise from OP to OP₁ as shown in Fig. 4.15. Here equilibrium quantity will increase from PE to P₁E₁.

Fig. 4.15

(iii) When increase in supply is more than increase in demand, new equilibrium price will fall from OP to OP₁ as shown in Fig. 4.16. Here equilibrium quantity will increase from PE to P₁E₁.

Fig. 4.16

(b) Effect of simultaneous leftward shift (i.e., decrease) in demand and supply. As discussed in part (a), we can analyse this situation in the similar manner. (i) When decrease in supply is equal to decrease in demand, the price will not be affected but the quantity will decrease in the same ratio. (ii) When decrease in supply is more than the one in demand, equilibrium price will increase and quantity will fall. (iii) When fall in supply is less than the fall in demand, equilibrium price will be less than the original price. The equilibrium quantity will fall.

Note : It is possible that the demand curve shifts rightwards and supply curve leftwards. In that case market price will definitely increase but quantity may increase or decrease. If demand curve shifts leftwards and supply rightwards, market price will decrease but quantity sold and purchased may increase or decrease.

Conclusion.

(i)    Rightward shift (i.e., increase) in demand leads to increase in equilibrium price and equilibrium quantity whereas leftward shift (i.e., decrease) in demand results in fall in both equilibrium price and quantity.

(ii)    Rightward shift (i.e., increase) in supply results in fall in price and rise in quantity. As against it, leftward shift (i.e., decrease) in supply gives rise to increase in price and fall in quantity.

(iii)    Simultaneous rightward shift (increase) in both demand and supply. Its effect depends upon whether the increase in supply is equal to or more than or less than the increase in demand. However equilibrium quantity will definitely increase.

(iv)    Simultaneous leftward shift (decrease) in demand and supply may lead to rise or fall in price or may not even affect the price depending upon the comparative rate of decrease in demand and supply. But the equilibrium quantity will fall definitely.

(i)    Change in price of related goods (substitute/complementary) in consumption. Take the example of two substitute goods tea and coffee. If price of coffee rises, demand for its substitute tea will also rise causing rightward shift of demand curve for tea. Effect on price and quantity? The price of tea and its quantity exchanged will increase. Now take two complementary goods tea and sugar. If price of tea goes up, demand for sugar (along with tea) will fall causing leftward shift of demand curve for sugar. Effect? Price of sugar and its quantity exchanged will decrease.

(ii)    Change in Income. When aggregate income of an economy rises, (i) demand for normal goods will increase (i.e., more demand at same price) and shift the demand curve rightwards but (ii) demand for inferior goods will fall and shift its demand curve leftwards. Effect? The price and quantity exchanged of a normal good will increase but those of an inferior good will fall. Reverse of it will happen if aggregate income of an economy falls.

(iii)    Change in Taste. The latest medical research has proved that mustard oil (Sarson ka Tael) is the best oil for heart patients for maintaining a healthy heart. A sudden spurt or increase in demand for mustard oil will shift the market demand curve to the right. Effect? The price and quantity purchased and sold of mustard oil will increase. The opposite will happen if there is unfavourable change in taste due to some reasons, i.e., in that case price and quantity exchanged of the commodity will decrease.

(iv)    Change in number of consumers in the market. An increase in population or number of consumers will shift rightward the market demand curve for a commodity. Effect? The price and quantity exchanged of the commodity will rise. On the contrary, a decrease in population will shift leftward the market demand curve which will result in fall in price and quantity exchanged.

(i)    Change in Price of Factor Inputs. An increase in price of factor inputs (i.e., wages, interest, rent etc.) increases the cost of production leading to decrease in supply and thereby shifts the supply curve to the left. Effect? The price of the product increases and quantity exchanged falls. The opposite happens when price of factor inputs falls, i.e., in that case supply curve shifts rightwards leading to decrease in price of the product and increase in quantity exchanged.

(ii)    Technological Progress. Since cost saving technical progress reduces cost of production, it will cause increase in supply. Therefore, technological progress shifts the supply curve to the right. Effect? As a result the price of the product falls and quantity exchanged rises. On the other hand, old and obsolete technology increases cost of production and shifts the supply curve to the left.

(iii)    Increase in Price of Related Good (substitute good) in Production. An increase in price of a substitute good in production shifts the supply curve of the given product to the left (because the producer now prefers to produce the substitute good which gives him more profit). Effect? The price of the given product will increase and the quantity exchanged will decrease. The opposite happens when price of a substitute good falls, i.e., supply curve shifts to the right resulting in a decrease in price of the given product and an increase in quantity exchanged.

(iv)    Change in Excise Duties. An increase in excise duty rates on production of a product shifts its supply curve to the left leading to an increase in the price of the product and fall in quantity exchanged. On the contrary, a decrease in excise duty rates shifts the supply curve to the right resulting in a decrease in price of the product and increase in quantity transacted.

(v)    Number of Firms in the Market. An increase in the number of firms in the market (reflecting greater competition) shifts the market supply curve to the right leading to fall in price of the product and rise in quantity transacted. As against it, a fall in number of suppliers in the market shifts the market supply curve to the left with the effect that price of the product rises and quantity exchanged falls. Obviously, more firms imply more competition and less number of firms implies less competition.

(vi)    Other Factors causing shift in supply are: change in weather conditions, (like floods, droughts), change in goals (objectives) of producers, future expectations of price changes etc.

We have read that in a freely functioning market, equilibrium price of a commodity is determined by market forces of demand and supply without any interference by the government. But sometimes equilibrium price so determined is too high for the consumers or too low (i.e., unprofitable) for the producers of the commodity. In such a situation government intervenes directly and indirectly for changing the equilibrium price, i.e., it fixes the price either below the equilibrium price or above the equilibrium price as explained below.

Direct intervention. (Through control price and support price) — It refers to government policies by which prices are fixed directly by the government. This is done in two ways— through control price and support price. For example, to protect the interest of consumers, government fixed the maximum price of a commodity (like sugar) which is lower than the equilibrium price. This is called control price or price ceiling. Similarly, to protect the interest of producers like farmers, government fixes the minimum price of a commodity (like sugar cane) which is generally higher than the equilibrium price. This is called support price.

Indirect intervention. (Through taxes and subsidies) — When government influences market price indirectly by imposing taxes and giving subsidies, it is called indirect intervention. For example, in Delhi toned milk is sold by mother dairy @ र 29 per litre whereas it costs government र 31 per litre. It is a subsidised price because difference of र 2 per litre is paid by the government as subsidy.

Effects of government's intervention

(i)    Rationing. It is a system of distributing essential goods in limited quantities at control prices. This is done through Fair Price Shop. Rationing is resorted when due to shortage, a good is not available at reasonable price. Government establishes Public Distribution System (PDS) as a tool to help the consumers especially vulnerable sections of society through Fair Price Shops. A fair price shop is one which sells goods at control prices. Government may supply sugar (or any other commodity in shortage) at fixed price through Fair Price Shops so that a part of demand of all the buyers is satisfied.

(ii)    Black-Market. Another result of price control can be emergence of black-market in which the commodity, (here sugar) is sold at a price higher than the government fixed price (here र 10). The reason is that, on the one side, sellers are not ready to sell at a lower price fixed by the government and, on the other side, some consumers are ready to offer a higher price to satisfy their demand for sugar. In practice, it is difficult to prevent black-marketing when government controlled price is lower than the equilibrium price. A black-market is an illegal market in which goods are sold at prices higher than the price fixed by the government by law.

(iii)    Dual-marketing. To avoid the situation of black-market, government sometimes introduces a system of dual-marketing. It is a system of having two prices for the same commodity at the same time. Accordingly a certain quantity of the commodity (here sugar) is supplied to consumers at fixed price through Fair Price Shops and at the same time that commodity is made available in the open market at a price determined by free forces of demand and supply.

(b)    Support Price. When government fixes price of a product at a level higher than equilibrium price, it is called support price (or floor price). Floor means the lowest limit. It is the minimum price at which a commodity can be purchased. It leads to more supply and short demand. As a result supply becomes in excess of demand. Support price is generally fixed for agricultural products like foodgrains, sugar etc. to safeguard the interests of producers (farmers). This price is also called floor price because it is the minimum price fixed by the government. Suppose government fixes price of sugar at र 20 per kg. In that case demand is for 40 tons whereas supply at this price is 80 tons creating again disequilibrium or surplus of 40 (= 80 - 40) tons. This is shown as surplus in Fig. 4.17. In such a situation government may purchase large amount of excess supply of sugar (or any other product for that matter) at its fixed price (called support or procurement price) to protect the interest of producers like farmers. Support price is the minimum guaranteed price at which producers can sell their output to government if so desired. It is higher than equilibrium price. For instance, a government agency, Food Corporation of India purchases wheat from the farmers at its fixed (support) price and stores it in godown as buffer stock. The main consequence of support price is that consumers have to pay higher price for the good. Moreover, income of the farmers (producers) goes up. The aim of support price is to insulate farmers from the fluctuations in their incomes caused by price variations in the free market.

(c)    Minimum Wage Legislation. Like fixation of minimum price (i.e., support price) of an agricultural crop, government fixes minimum wage of labourers by law at a level higher than what the free market forces of demand and supply would determine it. The aim is to help the labourers and provide them social security since their bargaining power is quite weak. But experience shows that in real life, government implements minimum wage fixation in public (government) sector whereas due to lack of enforcement machinery, it is rarely implemented in private sector. Government should ensure that the employers pay to their employees the minimum wage fixed by the government.

(i) When government fixes price of a product lower than the equilibrium price to help the consumers, it is called control price.

(ii) When government fixes the price of a product higher than the equilibrium price to help the producers, it is called support price.

(i) Equilibrium (market) price and quantity will increase presuming supply to be constant.

(ii)    It will lead to decrease in price and increase in quantity transacted.

(iii)    Equilibrium price will not be affected but quantity supplied and demanded will decrease in the same ratio.

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