IGCSE Economics Paper-1: Specimen Questions with Answers 4 - 4 of 27

Question number: 4

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What are the factors that firms might consider while determining a minimum price in a free competitive market?

Explanation

The forces of demand and supply play an important role to determine the price of a commodity in a free competitive market. Firm’s decision to determine the minimum price of a commodity is affected by following factors.

  • Time period: Time element affects the firms’ decision to fix the price. Time period can be very short period, short period and long period. In a very short period, goods are divided into two categories-Perishable goods and Durable goods. Perishable goods are those goods which perish very early e. g. fruits, vegetables, milk etc. In a very short period supply of these goods cannot be increased if demand increases.

  • In this period demand plays a dominant role in determining the price of a good. If demand increases, the price of the good will increase. But some goods are durable goods and such goods can be stored for a long time e. g. utensils, oil, soap, grain. Firms set a reserve price of such products and below which they will not sell these goods.

  • When the prices of these durable goods fall below the reserve price, the firms instead of selling these durable goods at a loss put them in store and wait for such time as the demand increases and price goes up. Hence the supply of durables cannot be increased beyond the existing stock limit.

  • But in the short period firms can produce upto its existing capacity. Firms will continue to produce in the short period even when they are incurring the loss of average fixed costs. Since firms will have to incur the loss of the fixed cost, even if they shut down the business. Price will be determined at a point when demand is equal to supply.

  • In the long period, normal prices are prevailing in the market. The forces of demand and supply have sufficient time to adjust itself.

  • Cost of Production: The total cost of production affects the determination of price. Cost of production is of three types-fixed cost, variable cost and semi variable cost. Fixed costs remain fixed during the course of production. It does not change with the level of production. But variable cost changes with the level of production. No firm will set the price below the fixed cost of production. Firm will charge a price more than or equal to average variable cost.

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