Price Determination Under Perfect Competition

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How are Prices Determined Under Perfect Competition?

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.

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 is equilibrium price 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 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. 

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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.

FAQ (Frequently Asked Questions)

Q1. How does Price Determination Take Place in a Perfectly Competitive Market?

Ans: Considering the perfect competition, the separate firms are the individual price takers here. They follow the price as set by the industry. Price determination takes place due to the intersection of demand and supply curves. It explains how prices are determined under perfect competition. Notably, there is a difference between the demand curve of an individual firm to that of the market. Under perfect competition, the sellers sell the same products and there are free entry and exit of firms in the market. The perfect competition typically depicts a theoretical market model. Hence, under perfect competition, the price is determined at the point where demand and supply graph intersects.

Q2. Why is There the Existence of Market Price in a Perfectly Competitive Market?

Ans: The perfectly competitive firm is denoted as the price taker. This is due to the pressure from their competitors to oblige them to accept the ongoing equilibrium price in the market. The market price is determined by the forces of demand and supply. A fall in the market price may degrade the overall prioritization factors of the firm. Without a proper market price, the product will cease to exist. For example, if there is no fixed price of gold, various sellers will sell the gold at the cheapest rate and hence the overall value of gold will fall. To maintain the value of a product, the market price is vital.