Perfect Competition: Price Determination

The One Thing

Under perfect competition, market demand and market supply determine the equilibrium price and quantity. Individual firms are price takers: they accept the market price and choose their output accordingly.

Who and What

• Perfect Competition: A market structure in which many firms sell identical products and no individual buyer or seller can influence the market price. Its main assumptions are a large number of buyers and sellers, homogeneous products, free entry and exit, perfect knowledge, free movement of factors of production, and no significant transport or selling-cost differences.
• Price Taker: A firm that accepts the price determined by market demand and supply because its own output is too small to affect the market. A perfectly competitive firm can sell any reasonable quantity at the market price, but cannot charge a higher price because buyers can purchase the identical product from other firms.
• Homogeneous Product: A product identical in quality, appearance, and use across all sellers.
• Market Demand: The total quantity of a good that all consumers are willing and able to buy at different prices during a given period. It generally slopes downward: quantity demanded falls when price rises, other factors remaining constant.
• Market Supply: The total quantity of a good that all producers are willing and able to sell at different prices during a given period. It generally slopes upward: quantity supplied rises when price rises, other factors remaining constant.
• Equilibrium Price: The price at which quantity demanded equals quantity supplied.
• Equilibrium Quantity: The quantity bought and sold at the equilibrium price. Equilibrium can be identified in a schedule where quantity demanded equals quantity supplied or on a graph where the demand and supply curves intersect.
• Excess Demand: A situation in which quantity demanded is greater than quantity supplied at a given price. This creates a shortage and upward pressure on price.
• Excess Supply: A situation in which quantity supplied is greater than quantity demanded at a given price. This creates a surplus and downward pressure on price.
• Firm’s Demand Curve: Under perfect competition, the demand curve faced by an individual firm is perfectly elastic, or horizontal, at the market price. This differs from the downward-sloping market demand curve.
• Revenue: The income earned by a firm from selling its output.
• Average Revenue: Revenue earned per unit of output.

$$AR=TR÷\text{Quantity sold}$$

• Marginal Revenue: The additional revenue earned by selling one more unit of output.

$$MR=\text{Change in TR}÷\text{Change in quantity sold}$$

• Total Revenue: The firm’s total income from sales.

$$TR=\text{Price}\times \text{Quantity sold}$$

• Perfectly Competitive Firm’s Revenue Relationship: For a perfectly competitive firm:

$$\text{Price}=AR=MR$$

Causes and Consequences

• A large number of buyers and sellers, homogeneous products, perfect knowledge, free entry and exit, free movement of factors of production, and no significant transport or selling-cost differences prevent any individual firm from controlling the market price. Consequently, each firm is a price taker.

• Market demand and market supply interact to determine the market price. The individual firm accepts this price because its own output is too small to affect total market conditions.

• Market equilibrium occurs when:

$$Q_d=Q_s$$ where $Q_d$ is quantity demanded and $Q_s$ is quantity supplied. At this point, the equilibrium price and equilibrium quantity are established.

• If:

$$Q_d>Q_s$$ excess demand or a shortage occurs. Buyers compete for limited output, creating upward pressure on price.

• If:

$$Q_s>Q_d$$ excess supply or a surplus occurs. Sellers reduce prices or otherwise adjust their decisions, creating downward pressure on price.

• A price above equilibrium tends to create a surplus, whereas a price below equilibrium tends to create a shortage. These pressures move the market towards the equilibrium price, making equilibrium stable.

• The market demand curve slopes downward, while the demand curve facing an individual perfectly competitive firm is horizontal at the market price. The market demand curve reflects all consumers’ decisions; the individual firm’s curve reflects the firm’s inability to influence price.

• An increase in demand, caused for example by changes in consumer preferences, income, the prices of related goods, or the number of buyers, generally raises both equilibrium price and equilibrium quantity. A decrease in demand generally lowers both.

• An increase in supply, caused for example by improved technology, lower input costs, subsidies, or an increase in the number of sellers, generally lowers equilibrium price and raises equilibrium quantity. A decrease in supply generally raises equilibrium price and lowers equilibrium quantity. Taxes and other changes affecting production costs can also shift supply.

• Price determination is dynamic. When consumer preferences, income, prices of related goods, technology, input costs, taxes, subsidies, or the number of buyers or sellers change, buyers and sellers adjust their decisions until a new equilibrium is reached.

• Because the individual firm faces a perfectly elastic demand curve at the market price, it can sell any reasonable quantity at that price. It cannot charge more than the market price because consumers can buy the identical product from another firm.

• For a perfectly competitive firm, price, average revenue, and marginal revenue are equal:

$$\text{Price}=AR=MR$$ Total revenue is calculated as: $$TR=\text{Price}\times \text{Quantity sold}$$ Average revenue is: $$AR=TR÷\text{Quantity sold}$$ and marginal revenue is: $$MR=\text{Change in TR}÷\text{Change in quantity sold}$$

What Gets Asked

• Explain how market demand and market supply determine equilibrium price and equilibrium quantity under perfect competition.
• Distinguish between the downward-sloping market demand curve and the horizontal demand curve faced by an individual perfectly competitive firm.
• Explain why excess demand creates upward pressure on price and excess supply creates downward pressure on price.
• Analyse the effects of increases and decreases in demand and supply on equilibrium price and equilibrium quantity.
• Explain why a perfectly competitive firm is a price taker and why it cannot charge a price above the market price.
• Calculate and interpret total revenue, average revenue, and marginal revenue using:

$$TR=\text{Price}\times \text{Quantity sold},AR=TR÷\text{Quantity sold},MR=\text{Change in TR}÷\text{Change in quantity sold}$$