Price Determination in Perfect Competition Explained

In a Perfectly competitive Market, several influential factors determine the Price of commodities. For example, if the demand is high and supply is low, then the Price will increase. During a storm or flood, you will notice that the Price of groceries rises tremendously. This is because the storm or flood has destroyed the crop, and hence the supply reduces. However, since the demand for groceries is still high, therefore, the Price automatically increases. On the other hand, if the supply is more than demand, then the Price will drop. Equilibrium of both the industry and the firm is significant in Price Determination under a Perfect Competition Market. Here, we will discuss in detail how the Price is determined under Perfect Competition and both the factors of Equilibrium, holding enough importance in Price Determination.

A Market situation with many homogeneous product suppliers is called Perfect Competition. A single Company provides a small portion of total production and is not powerful enough to affect Market Prices. 

However big the investor is, he cannot control the Market rates which are determined by the interaction of Market supply and demand forces in an extremely competitive field. Market demand represents the sum of the quantities required by individual buyers at different Prices. The Market supply is also the sum of the quantities offered by individual companies in the sector. All sellers and buyers accept fixed Prices. Therefore, the main issue for profit maximization companies in a Perfectly competitive Market is not to determine the Price of the product, but to adjust the production to the Market Price in order to maximize the profit. 

Pricing under Perfect Competition will be considered in three different periods- 

1. Market Period

2. Short Run

3. Long Run 

Market Period

In a Market period, the time span is so Short that no one can increase its output. The Market period of the stock may be an hour, a day or a few days or even a few weeks depending upon the nature of the product.

For example, in the case of perishable stock such as vegetables, fruits, fish, eggs, baked goods the period may be limited by a day or two by quantity available or stock in a day that neither can be increased nor can be withdrawn for the next period, the entire stock must be sold away on the same day, whatever may be the Price. 

Short Run 

Short term means that amount of time is not enough to change the fixed input or the number of companies in the industry, but it is enough to change the output by changing the variable input. 

In the Short term, there are two distinct costs: (i) fixed costs and (ii) variable costs. 

Fixed costs in the form of fixed elements, i. H. Plants, machines, buildings, etc. do not change as the Company's production changes. When a Company increases or decreases production, changes are only made to the number of variable resources such as labour and raw materials. 

In the Short term, the demand curve facing the Company is also horizontal. The number of companies in the industry remains the same since no new Company can enter nor can any Company leave. With Perfect Competition, the Company accepts the Prices of the products on the Market. The Company sells all products at current Market Prices. 

Long Run 

A Long term is a time period Long enough to allow you to change both variable and fixed factors. Therefore, in the Long run,  all factors are variable and not fixed. Therefore, in the Long run, companies can change production by increasing fixed equipment. You can modify old plants, or replace them with new ones. 

In addition, in the Long run, new companies can also enter the industry. Conversely, if needed, fixed equipment can be used up without replacement, in the Long run,  allowing existing companies to leave the industry as well. So there is no stop to companies entering or leaving.  

Conditions for Company Equilibrium  

To achieve Equilibrium, a Company must meet two conditions: 

You need to make sure that the marginal revenue is equal to the marginal cost (MR = MC). 

1. If MR> MC, the Company has an incentive to expand production and sell additional units. 

2. If MR<MC, the Company needs to reduce production because additional units generate more costs than revenue. 

Only when MR = MC does the Company achieve maximum profit.

Equilibrium of the Industry in a Perfectly Competitive Market

In Economics, the industry comprises several firms. Each of the firms consists of factories or mines, as per the requirement. If the total output of the industry equals the total demand, then the Equilibrium is created. In this situation, the ongoing Price of the good is noted to be its Equilibrium cost. While determining how Equilibrium Price is determined under Perfect Competition, we will need to discuss the following theory.

Equilibrium of the Firm in a Perfectly Competitive Market

When there is profit maximization, the firm is said to be in Equilibrium. The input that provides the highest output to that particular firm, is known as the Equilibrium output. In such a state, there are no factors to increase or reduce the output. The firm is the Price taker in a competitive Market. They produce homogenous commodities. Therefore, influencing the pricing factors isn't on the will of the firms. They strictly follow the Price structure, as stated by the industry. This is how Price and output Determination under Perfect Competition is done. Now, we will explore more on the topic of how Prices are determined under Perfect Competition. 

Price Determination in a Perfect Competition Market

In a Perfectly Competitive Market or industry, the Equilibrium Price is determined by the forces of demand and supply. Equilibrium signifies a state of balance where the two opposing forces operate subsequently. An Equilibrium is typically a state of rest from which there is no possibility to change the system. Market Equilibrium takes place when both the demand and supply balance each other, i.e., there’s no difference between these opposing forces and are at rest. The following theory will explain how Equilibrium Price is determined under Perfect Competition. 

(Image to be added Soon)

The figure indicates a normal shaped Market demand and Market supply curves. The demand curve DD and supply curve SS, intersect each other, and we get Equilibrium Price aLongside Equilibrium quantity. The Equilibrium Price is OP* whereas the Equilibrium quantity is OQ*. At this Price, the amount that the sellers desire to sell in the Market is exactly matched by the quantity that the consumers are willing to purchase. At this Price, both sides get satisfaction. Therefore, neither of the two parties are interested in disturbing this situation.

The Equilibrium Price OP* is described by the intersection of both the demand and supply curves. This is also termed as the "Market clearing Price" since at this cost, both the excess supply and demand remains nil. We can explain it like this. 

If the Price gets higher than OP*, like OP1, consumers desire to get P1M1, whereas sellers are willing to sell more quantity. Therefore, the situation of excess supply turns up. Sellers are not happy. Resultantly, there will be downward pressure in Price (as Competition between sellers hikes up). The Price shall be falling until it reaches OP*. Similarly, at a Price lower than OP*, like OP2, there will be an excessive demand or Shortage in the Market. Then, the buyers get dissatisfied. Competition between consumers will hike up, leading to upward pressure in Price. It continues until OP* is attained. Therefore, OP* is Equilibrium Price or Market-clearing cost. Or, all other Prices except OP* are disEquilibrium costs. The total theory indicates how Prices are determined under Perfect Competition in a Market. 

Did You Know?

Here are some amazing facts to know about Equilibrium Price Determination under Perfect Competition.

• The Perfectly competitive firm is noted to be the Price taker. 

• The Perfect Competition takes place amidst many sellers and free entry and exit of the firms from the Market.

• When both the supply and demand increase, the Equilibrium amount purchased and sold will increase too. 

• According to neoclassical economists, the concept of a Perfectly competitive Market is an abstract concept.