The relative importance of supply on demand in the determination of price depends upon the time given to supply to adjust itself to demand.
To study the relative importance of supply or demand in price determination, Prof. Marshall has divided time element-into three categories:
(a) Very short period or market period.
(b) Short period.
(c) Long period.
Now we shall discuss the price determinant in different period.
(a) Very short period (determination of market price):
Market period is a time period which is too short to increase production of the commodity in response to an increase in demand. In this period the supply cannot be more than existing stock of the commodity.
The supply of perishable goods is perfectly inelastic during market period. But non-perishable goods (durable goods) can be stored.
Therefore, the supply curve of non-perishable goods above reserve price has a positive scope at first but becomes perfectly inelastic after some price level.
The reserve price y depends upon-(i) cost of storing, (ii) future expected price, (iii) future cost of production, and (iv) seller’s need for cash we will discuss the determination of market price by taking a perishable commodity and determination of market price is illustrated.
DD is the original demand curve and SS the market period supply curve. The demand curve DD (perfectly inelastic) cuts the supply curve SS at point E. Point E, is the equilibrium point and equilibrium price is determined at OP, level.
Increase in demand shifts the demand curve to D,D and the price also increased to OP,. Decrease in demand shifts the demand curve downward to D2D2 and the price too falls to OP It is, thus, clear that in market period price fluctuates with change in demand conditions.
(b) Price determination is short period:
In the short period fixed factors of production remain unchanged, i.e., productive capacity remains unchanged.
However, in the short period supply can be affected by changing the quantity of variable factors.
In other words, during the short period supply can be increased to some extent only by an intensive use of the existing productive capacity.
Therefore, the supply curve in the short-run slopes positively, but the supply curve is less elastic. Determination of price in the short-run is illustrated.
SS is the market period supply curve and SRS is short-run supply curve. The original demand curve DD cuts both the supply curves at E, point and thus OP, price is determined.
Increase in demand shifts the demand curve upward to the right to D,D,. Now with the increase in demand the market price (in market period) rises at once to OP3 because supply remains fixed. But in the short-run supply increases. Therefore, in the short-run price will cuts the SRS curve. If demand decreases opposite will happen.
(c) Price determination in long period (Normal Price):
In the long period there is enough time for the supply to adjust fully to the changes in demand.
In the long period all factors are variable. Present firms can increase on decrease the size of their plants (productive capacity).
The new firms can enter the industry and old firms can leave the market. Therefore, long-period supply curve has a positive slope and is more elastic than short period supply curve.
The shape of supply curve of the industry depends upon the nature of the laws of returns applicable to the industry. Price determination in the long period is illustrated.
DD is the original demand curve and LS is the long period supply curve of the industry. Demand curve DD and supply curve LS both intersect each other at E point and OP price is determined.
This price will be equal to minimum average cost (AC) of production because in the long period firms under perfect competition can only earn normal profits. Suppose these are permanent increase in demand.
With the increase in demand, the demand curve shifts to D1,D1. As a result of increase in demand the price in the market period and short period will rise.
Due to increase in price present firms will earn above normal profit. Therefore, new firms will enter into market in the long period.
As a result of it supply will increase in the long period. In the long period price will be determined at OP1, level because at this price demand curve D1 D2 cuts the LS curve at E2 point.
Price OP1, is greater than previous price OP1, because the industry is an increasing cost industry. This new higher price will also be equal to minimum average cost of production.