Short-run Fixed Price Analysis of Product Market

The prices in the short run take some time to react to factors of excess supply or demand as producers seek to modify their production plans in the meantime. For instance, if there is an excess supply, firms plan to produce less in the next cycle to prevent inventory accumulation. In addition, an individual firm is very small compared to the total market and cannot influence the market price.  As a result, an individual enterprise must accept the market pricing. The level of prices remains constant and only varies when the economy fails to eliminate the influence of excess demand or supply. So, it is assumed that prices would remain constant in the short term and change in the long run.

It is also assumed that supply elasticity is infinite which indicates that suppliers are willing to supply whatever amount that consumers will demand at a given constant price, to determine aggregate demand under fixed final goods prices (i.e., in the short term). It is an essential assumption because if the amount supplied exceeds or falls short of the quantity demanded at that price, the price will vary due to excess supply or demand. So, when aggregate supply is considered to remain constant, aggregate demand alone determines equilibrium. It is known as the Effective Demand Principle. Effective demand is the overall demand for a good or service that the corresponding supply satisfies.

Determination of Equilibrium Output under the Fixed Price Model

According to the Fixed Price Model, the equilibrium output of final goods is completely determined by aggregate demand (AD). AD is a function of Consumption (C) and Investment (I) in a two-sector model; i.e.,

AD = C+I……………….(i)

Also, the consumption function is presented by:

…………….(ii)

Where,  = Autonomous Consumption; b = MPC; and Y = Income

In addition, b or MPC represents the rate of the consumption function and shows the rate at which consumption rises with an increase in income. Besides, the investments are considered to be autonomous investments, which implies that they are not influenced by income level; i.e.,

I =  = Autonomous Investment ……….(iii) 

Putting the value of C from (ii) and I from (iii) in (i):

Now, the values of autonomous expenditure  and MPC (or b) determine the equilibrium level of national income (Y) or aggregate demand (AD). The equilibrium can be determined with the help of the below graph.

In the above graph, we can see that the AD line crosses the 45° line at point E when autonomous expenditure in the economy is A₁. The equilibrium output is OY at point E, which is determined as the equilibrium point. 

However, the AD line will shift to AD₁ if autonomous expenditure rises from A₁ to A₂. EG is the amount of excess demand as a result of a rise in autonomous expenditure. Point E will no longer be considered the equilibrium point at this time. A new equilibrium will be found when the new aggregate demand line, or AD₁, crosses the 45° line, which occurs at point E₁. This point represents the new equilibrium. At OY₁ and AD₁, the new equilibrium output and aggregate demand respectively will be determined.