Time Periods and Price Fixation
Time element plays an important role in economics. Modern economists divide time periods into short period and long period. The equilibrium price acquired above is valid only for a particular time period. Any change in demand and supply over a period of time will shift the demand and supply curves and different equilibrium will be obtained.
For instance, the flexibility of a firm in adjusting its production to meet the change in demand depends on the nature of its inputs. There are two types of inputs namely fixed inputs and variable inputs.
The fixed input is one whose quantity cannot be adjusted in a limited time period. Heavy machinery, buildings and capital equipments are such fixed inputs and they may need more time for installation or replacement.
However, variable inputs like labour, raw materials and electricity can be changed quickly to change the supply until the full plant capacity is reached. Now it is possible to distinguish between short period and long period. The short period for a firm is the time period during which at least one of the inputs is fixed input. The long period is the time period during which all the inputs are variable inputs.
The specific duration of the short period and long period will vary from firm to firm. A small Bonda stall on the roadside pavements can change all the inputs even within a single day, because all inputs are easily variable. The seller can install one more stove, use more oil and other ingredients of Bonda within a day to meet any sudden increase in demand. Hence, for him the duration of long period can even be a single day. On the other hand, installation of a specialized machinery for the Ariyalur cement plant may take years, because the production, transportation, installation require a long period of time.
Price Fixation in the Short Period
Alfred Marshall introduced time element in the determination of equilibrium and divided them into market period, short period and long period.
Market period is the period during which the ability of the firms to affect any changes in supply in response to any change in demand is extremely limited or almost nil. Thus supply is more or less fixed in the market period without any change. However, the demand may vary during this period.
The equilibrium price will be determined according to the changes in demand, given the fixed supply. Figure explains the equilibrium price in market period.
As the supply is fixed in the market period, it is shown as a vertical line SMP. It is also called as inelastic supply curve. When demand increases from DD to D1D1, price increases from P to P1. Similarly, a fall in demand from DD to D2D2 pull the price down from P to P2. The market for perishables can be a good illustration. The demand for plantain fruits increases during the festival season, so the prices will naturally go up as the supply cannot be increased immediately to meet the demand. Thus, demand determines the equilibrium price in the market period.
As mentioned earlier short period is the one during which at least one of the factors will be a fixed input and the supply will be adjusted by changing the variable inputs. The equilibrium price will be determined by adjusting supply (within the plant capacity) according to the changes in demand (Figure)
SSP is elastic implying that supply can be increased by changing the variable input. Note that the corresponding increase in price from P to P1 for a given increase in demand from D to D1 is less than that of the market period. It is because, increase in demand is partially met by the increase in supply from q to q1. Thus during the short period both demand and supply exert their influence on price and the equilibrium price is determined accordingly.
In the long period supply can be changed by changing all the inputs (both the fixed and variable inputs). Any amount of change in demand will be met by changing the supply, to the extent of changing the plant, machinery and the quantum of technology. In figure, the long period supply curve SLP is more elastic and flatter than that of the SSP. This implies the greater extent of flexibility of the firms to change the supply. The price increases from P to P2 in response to an increase in demand from D to D1 and it is less than that of the market period (P1) and short period (P2). It is because the increase in demand is fully met by the required increase in supply. Hence, supply plays a significant role in determining the lower equilibrium price in the long run.