Before Marshall there was controversy among economists as to whether the price of a commodity is determined by the utility (demand) or the cost of production (supply) of a commodity. According to a group of economists, people demand commodity because of its utility and pay the price according to the utility derived. Hence, the price should be determined on the basis of marginal utilities of commodities. The Austrian economists, particularly Karl Menger and Friedrich Wieser, were the strong supporter of this view.
According to another group of economists, in many commodities people get utility more than price paid. It is thus inappropriate to determine price on the basis of marginal utility. Hence, the price should be determined on the basis of cost of production. The classical economists, particularly David Ricardo, were the strong supporter of this view.
The famous economist Marshall resolved this controversy once and for all. He gave equal importance to both utility and cost or demand and supply. According to him, demand and supply both determine price. As opined by him “As both blades of a scissor are important for cutting a clothe, so is both demand and supply essential for determination of price”. The price is determined at a point where demand and supply are equal. The price so determined is called equilibrium price. The process of price determination is presented in table.
As shown in the table, the increase in price from Rs 10 to Rs 20 to Rs 30 leads to fall in demand. On the contrary, the increase in price, leads to increase in supply. When price Rs 30, the demand and supply are both equal, 150 units. Hence 150 units is the equilibrium quantity demanded and supplied and Rs 30 is the equilibrium price. When price is Rs 10, the demand is 250 units and the supply is 50 units. The demand is more than supply. Hence, the price increases and comes to Rs 30. Likewise, when price is Rs 50, the demand is 50 units and supply is units. The supply is more than demand. Hence, the price falls and comes to Rs 30.
The process of price determination has been presented in the figure below.
In prefect competition, the firms have no control over price. The market price for the industry is determined by supply and demand. There are industry demand curve and industry supply curve, aggregate of all customers and sellers. The intersection of industry supply and demand curves determines the market price. As shown in the figure below OP or Rs. 30 is the market price intersection of market supply and demand curves. E is the point of equilibrium where demand equals supply 150 units.
If price is Rs. 40, or higher than equilibrium price, supply 200 units > demand 50 units and price falls. Likewise, if price is Rs. 20 or less than equilibrium price, demand 200 units > supply 100 units and price increases. Finally, OP or Rs. 30 price rules in the market.