3 Main Reasons for the Market Price Fluctuations are described below:
‘Market price’ refers to the price prevailing at a point of time in the market. Over a period of time, fluctuations in the market price take place due to market imperfections. ‘Normal price’, therefore, is a price that stretches itself over a period of time.
In a competitive market, price is determined by the interplay of forces of demand and supply. The constituent firms adopt this price. Fluctuations in this price may arise under the following situations
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i. Shifts in demand
ii. Shifts in supply
iii. Government regulations
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i. Shifts in Demand:
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Shifts in demand are caused by shift factors such as change in income of consumers, change in prices of related goods, and change in tastes, preferences and fashions. A favourable change shifts demand upwards to right while an unfavourable one shifts it downwards. An increase or a decrease in population also leads to an upward or a downward shift in demand.
Figure 6.2 shows how an increase in demand influences market price.
ii. Shift in supply:
The effect of an increase or decrease in supply on the price-output decisions of an industry and the firm can be explained on similar lines. Increases/ decreases in supply are caused by shift factors (Section 2.9). Figure 6.4 shows the effect of an increase in supply on the price-output decisions of the industry and the firm.
Fig. 6.4: Increase in supply lowers the price; to restore which, demand needs to be increased as shown.
The industry may resort to aggressive marketing to increase demand in order to retain the original level of price.
When supply decreases, the supply curve shifts upwards to left and the market price rises in consequence. Figure 6.5 demonstrates the mechanism.
We have been how market forces influence price-output decisions of a competitive firm. In all the above cases, free play of the market forces remains undisturbed. Let us now examine some of the cases in which government action intervenes the free play of the market forces and tends to influence price-output decisions of the industry and the firm.
iii. Government regulations (direct intervention):
In respect of protected industries, government resorts to ‘price floors’ with a view to ensuring a certain minimum price to the producers. A price floor is a price fixed by government above the market price and is maintained at that level through deliberate action.
In the process, government has to resort to purchase the excess supply itself. Figure 6.6 demonstrates the mechanism.
Fig. 6.5: A decrease in supply leads to an upward-to-left shift in the supply curve. This increases price. In consequence, market demand drops from Q to Q’. The firm, being a price taker, adopts the higher price and suffers a fall in its quantity from q to q’. Now suppose government decides to stabilise prices.
It has two ways to do that. First, it should supplement the supply by offering stocks from its own sources. Second, it should decrease demand by forcing a reduction in disposable income of consumers. This would reduce sales of the industry, and hence, of the firms comprising it.
During harvests, the Indian government procures foodgrains at the floor-price to retain people’s interest in cultivation as a source of their livelihood. In India, a little over 68% of the labour force derives its livelihood from agriculture. To prevent flight of rural labour to the overpopulated urban areas suffering already from the problem of massive unemployment of the educated, it becomes imperative for the state to retain the rural work force to rural occupations only.
Apart from this, a sound agricultural sector is needed by the State not only for self-sufficiency in foodgrain production but also for rapid economic development of the nation. In addition, a welfare State needs to protect common consumers against exploitative trade practices of intermediaries, particularly, during the period of lean supply of foodgrains. The State has to ensure supply of essential commodities to people at fair prices during such periods. This is done by fixing price below the prevailing market price and undertaking to supply the deficit themselves.
Price so fixed by government is called ceiling price. The stocks raised by the procurement department of government during harvests come handy in this regard. Procurement of foodgrains at prices remunerative enough (through price-floors) for the cultivators on the one hand, and their distribution at prices reasonable enough (through price-ceiling) for the common people on the other, constitute the essential ingredients of public distribution system in India. Figure 6.7 demonstrates the working of price-ceiling as practised by welfare States.
Government regulations (indirect intervention):
The government regulation of market price discussed above provides an example of its direct intervention in free play of price mechanism. In addition, government resorts to some indirect measures as well that influence the market price. Such measures, called indirect intervention, include levy of sales tax and excise duty. Sales tax is a unit tax levied as a certain percentage of the product price on each unit sold. Excise duty, on the other hand, is a unit tax, levied as a fixed amount per unit of the output produced. Levy of unit taxes results in an upward-to-left shift in the supply curve. Here we will briefly introduce the effect of unit taxes on price-output decisions of the industry and the firm. Figure 6.8 explains the mechanism.
