As others have mentioned, every party member should be equipped with a bow (or wand), and you should have visited the Day of the Gods pedestal. Have Wizard Eye active.

Have the game in "Always Run" mode.

Enter turn-based mode before entering the cavern, and take your free potshots at the dragon while it kills the rats. Once the last rat is dead, save the game and go to real-time combat.

The dragon likes to circle you counterclockwise, so be accommodating and do likewise, so that you can circle each other, firing back and forth, without getting so close that Morcarack will actually hit you.

Run around the cave this way, listening for his breath weapon. Between his attacks, stop, turn to face him, and hold down Shift-A until all four of your characters have attacked. Release Shift, turn right, and run (continuing to cirle him) while he attacks. Turn back and Shift-attack again.

If you time it right, you can often get off one volley for each of his attacks. If your characters are taking too long to recover (that is, to be ready to attack again), keep running until he attacks twice, and then attack.

The trick is that Shift temporarily puts you back into "Walk" mode, which significantly decreases your characters' recovery time. But then, after releasing it, you still get to run fast enough to evade the breath weapon. (This doesn't affect your recovery time, even though you're still recovering while running!)

(Save the game frequently! On occasion, one does accidentally turn and get a face full of dragon breath. Yuck.)

Master this, and the dragon is toast.