1. Partial Equilibrium,
Reference Pricing and
Price Distortion

2. • Partial equilibrium is a condition of economic equilibrium which
takes into consideration only a part of the market, ceteris paribus, to
attain equilibrium.
• As defined by Leroy lopes, "A partial equilibrium is one which is
based on only a restricted range of data, a standard example is price of
a single product, the prices of all other products being held fixed
during the analysis.“
• The equilibrium of a single consumer, or producer, single firm or
single industry are examples of partial equilibrium analysis.
• The supply and demand model is a partial equilibrium model where
the clearance on the market of some specific goods is obtained
independently from prices and quantities in other markets.
• In other words, the prices of all substitutes and complements, as well
as income levels of consumers, are taken as given. This makes
analysis much simpler than in a general equilibrium model which
includes an entire economy.

3. • Here the dynamic process is that prices adjust until supply equals
demand. It is a powerfully simple technique that allows one to study
equilibrium, efficiency and comparative statics. The stringency of the
simplifying assumptions inherent in this approach make the model
considerably more tractable, but may produce results which, while
seemingly precise, do not effectively model real-world economic
phenomena.
• Partial equilibrium analysis examines the effects of policy action in
creating equilibrium only in that particular sector or market which is
directly affected, ignoring its effect in any other market or industry
assuming that they being small will have little impact if any. Hence
this analysis is considered to be useful in constricted markets.
• Léon Walras first formalized the idea of a one-period economic
equilibrium of the general economic system, but it was French
economist Antoine Augustin Cournot and English political
economist Alfred Marshall who developed tractable models to analyze
an economic system.

4. • Assumptions
• Commodity price is given and constant for the consumers.
• Consumers' taste and preferences, habits, incomes are also
considered to be constant.
• Prices of prolific resources of a commodity and that of other related
goods (substitute or complementary) are known as well as constant.
• Industry is easily availed with factors of production at a known and
constant price compliant with the methods of production in use.
• Prices of the products that the factor of production helps in producing
and the price and quantity of other factors are known and constant.
• There is perfect mobility of factors of production between occupation
and places.
• The above-mentioned points relate to a perfectly competitive market
but can be further extended to monopolistic
competition,oligopoly, monopoly and monopsony markets

5. • Applications
• Applications of partial equilibrium discusses, when does an individual, a firm,
an industry, factors of production attain their equilibrium points-
• A consumer is in a state of equilibrium when they achieve maximum aggregate
satisfaction on the expenditure that they make depending on the set of conditions
relating to his tastes and preferences, income, price and supply of the commodity
etc.
• Producers’ equilibrium occurs when they maximize their net profit subject to a
given set of economic situations.
• A firm's equilibrium point is when it has no inclination in changing its production.
• In the short run: Marginal Revenue = Marginal Cost.
• Algebraically MR=MC
• In long run: Long run Marginal Cost = Marginal Revenue = Average
Revenue = Long run Average Cost
• Algebraically LMC=MR=AR=LAC at its minimum are the conditions of
equilibrium. It means that a firm is earning only a "normal profit" and has no
intension to leave the industry.

6. • Equilibrium for an industry happens when there is normal profit
made by an industry. It is such a situation when no new firm wants
to enter into it and the existing firm does not want to exit.
• Only one price prevails in the market for a single product where the
quantity of goods purchased by a buyer = total quantity produced by
different firms. All the firms produces till that level where Marginal
Cost=Marginal Revenue, and sells the product at market price
ruling at that point of time.
• Factors of production, i.e., land, labor, capital, and entrepreneurs are
in equilibrium when they are paid the maximum possible so as
maximize the income. Here the Price = Marginal Revenue
Product.
• At this price it does not have any enticement to look
for employment anywhere else.
• The quantity of factors which its owners want to sell should be equal
to the quantity which the entrepreneurs are ready to hire.

7. • Limitations
• It is restricted to one particular portion of the economy.
• It lacks the ability to study the interrelations of all the parts of
the economy.
• This analysis will fail if the improbable assumptions, which
disconnect the study of specific market from the rest of
the economy, are not taken into consideration.
• It has been unsuccessful in explaining the outcome
of economic disturbance in the market that leads
to demand and supply changes, moving from one market to another
and thus instigating second- and third-order waves of change in the
whole economy.

8. • In partial equilibrium the welfare effects on consumers who purchase and the
producers who produce in the market is distinguished by consumer surplus and
producer surplus.
Consumer surplus
• The amount that a consumer is ready to pay for a particular good minus the
amount that the consumer actually pays. The amount that the consumer is
willing to pay has to be greater.
• In the graph given here, P1 is the price that a consumer is ready to pay for a
particular product. But the producer may reduce the price to P2 expecting that
either more people would buy at the reduced rate, or the person who was ready
to pay P1 will purchase more of the same. The producer may further reduce the
price to P3, again expecting more buyers or the same buyers purchasing more.
• The price keeps on falling until P’, where the demand and the supply curves
intersect: their intersection is the equilibrium point. Hence the consumer
surplus for first consumer can be calculated as P1 - P’, decreasing for the
second consumer to P2 - P’, and so on. Thus the total consumer surplus in the
market can be obtained by summing up the three rectangles. The triangle with
the purple outline to the left indicates that area

10. Producer surplus
• Amount that a producer finally receives by selling a particular
product minus the amount the producer is ready to accept for that
good. The amount that the producer receives should be greater.
• If only one unit of the commodity was demanded at the price P1,
this becomes the price which the producer expects to receive. But if
two units are demanded, the minimum price at which the producer
would be ready to increase the supply shifts to P2. This continues
and the final price that ultimately prevails in the market is P’, the
price which is obtained by the intersection of
the demand and supply curve in the market. The producer's surplus
here would be initial price minus the final price. And total
consumer surplus in the market will be summation of the three
rectangles

11. Reference pricing
• Reference pricing refers to how much consumers expect to pay for
a good in relation to other competitors and the previously
advertised price.
• Reference pricing could refer to a situation when a firm sells price
just below the main price of its competitor.
• Reference pricing also refers to a situation where a firm sells a
good at a large discount to a previously advertised ‘reference price’
• When buying goods consumers give importance to comparing the
price of the good with a ‘reference price’ The price that they would
usually expect to pay or the price they think the good is worth
using all previous data.

12. • Setting an Artificially High Reference Price
• Companies may seek to establish an artificially high reference price
for its product so that it can later offer discounts. For example, it is
common for clothes shops to introduce clothes at a high price, e.g.
Rs.2000 But, then after a few weeks, they offer 50-60% discount.
Consumers think they are getting a good deal because they have a
50% discount on the reference price.
• Reference Pricing can be considered unfair competition. There are
certain laws about offering discounts on advertised prices. For
example, shops have to sell goods at a set price in all its stores for a
minimum time period before cutting price.
• The reports found that this kind of reference pricing can
significantly increase consumers’ valuation of what they were
buying.
• A report found that a particular company was guilty of many unfair
business practices, including reference pricing.

13. Price distortions
• Price distortions are apparent price-value gaps. Trading strategies
that are based on such distortions rely less on information advantage
than on consistent price monitoring, flexibility of trading,
privileged market access, superior financial product knowledge
and most of all rational discipline in turbulent times. Price
distortions arise from inefficient flows and prevail as long as a sizable
share of market participants is either unwilling or unable to respond
to obvious dislocations. There are many causes of such inefficiencies,
including risk management rules, liquidity disruptions, mechanical
rebalancing rules and government interventions.
• What are price distortions?
• In the present context price distortions are defined as deviations of
quoted prices from a level that would clear the market if all
participants were trading for conventional risk-return optimization. In
short, they measure gaps between mark-to-market prices and a
plausible range of economic values of a contract. The occurrence of
distortions implies that market prices can deviate from fundamental
value and evidently so.

14. • Like information inefficiency, price distortions lead to a mispricing of
financial contracts relative to their fundamental value. However,
this mispricing is not based on ignorance, but on ”inefficient flows”.
These are transactions in financial markets that are motivated by
objectives other than return optimization. In practice, one can
observe many market flows and transactions that obstruct the
alignment of price and value. Common causes or triggers for such
“inefficient flows” include:
• formal and rigid risk management rules across that apply to many
institutions,
• liquidity shocks, i.e. a sudden deterioration of the tradability of
assets or the risk thereof,
• mechanical allocation rules, for example of exchange traded funds,
indexed fund and related structured products, and
• government intervention and regulation.

15. • Detecting price distortions
• Unlike information-based trading, price distortion-based strategies do not
require a great information advantage.
• Price distortions frequently arise pursuant to major information or price
shocks that create a state of confusion or even panic. Moreover, trading in
times of turmoil often bears high transaction cost, which deter market
participants from immediately taking advantage of price-value gaps.

16. • In order to detect price distortions systematically one can take
three different angles:
• The first is to understand and identify the causes of distortions,
such as institutional risk management constraints.
• The second angle are metrics of misalignment between prices and
fundamental value, such as in financial bubbles
• The third approach is to investigate the time series pattern of
asset prices.