How is price determined in a competitive market

This would go on till p falls to the level of p 0 and market equilibrium is restored. We have discussed above how the price is determined in a perfectly competitive market through the process of interaction between demand and supply for the good.

We have also seen when and why the market equilibrium may be considered to be stable. As we have seen above, price is determined in a perfectly competitive market through interactions between demand and supply. That is, demand and supply have an equally important role to play in the process of price determination.

According to the law of demand, as price of the good increases or decreases, the quantity demanded of it decrease or increases. Again, because of the law of supply, as price increases or decreases, the quantity supplied also increases or decreases.

We generally assume that if the price of good changes, its buyers may instantly change the quantity of its purchase. They do not require any time lag to do this. On the other hand, if the price of a good changes, then, whether quantity produced and supplied of it would actually change, and by how much, would depend on the length of time given for adjustment.

For example, if the price of a good increases, then its producer will want to supply more. But within a short span of time he might not be able to increase supply as such as he wished. However, if he is allowed a longer span of time, he might be able to produce more. This is because, as we know, in the short run, he cannot change the quantities of the fixed inputs which he may do in the long run.

Now, as we have seen above, the length of time obtained for necessary adjustments will determine the extent of change in quantity supplied and thereby influence the price.

That is why it is said that time plays an important role in price determination in a perfectly competitive market. We may discuss the process of price determination in this market in three phases, depending on the length of time given for adjustment. Very short period is a short span of time during which the supply of the good, generally, cannot be changed.

For example, the market for a good during the morning of a day may be called a very short period market. The supply curve of the good in such a market would be like the SS curve in Fig. In this market, since the quantity supplied cannot change in response to a change in price, most of the supply curve would be a vertical straight line.

However, if the price falls below a certain low level, the sellers might think it prohibitively low and then, as price decreases further, they might attempt to reduce the quantity supplied of the good. In Fig. This price is known as the reservation price. Therefore, at the point of intersection, E 1 , of the DD 1 and SS curves, the very short period market price of the good, p 1 , and the equilibrium quantity, q 1 , would be determined. In order to see the importance of time in price determination in a competitive market, let us suppose that there has been an increase in demand due to some reason, and the demand curve for the good has shifted to the right from D 1 D 1 to D 2 D 2.

At any particular price, demand for the good would now increase, and the buyers would now be willing to pay a higher price. Consequently, the price of the good would be rising. Since the supply curve, SS, is a vertical straight line, the shift in the demand curve would cause the equilibrium quantity bought and sold to remain constant at q 1. If demand increases in the very short period, only price would change, by a rather large amount, and, supply would remain constant. Time span in the short period is larger than that in the very short period.

We have already known what we understand by the short period or short run in our discussion of the theories of production and cost. We know that the firm can change the quantity of output produced and supplied in the short run by changing its use of the variable inputs. Therefore, the firm can increase the quantity supplied of the good in the short run in response to an increase in its price.

That is, in the short period, since supply can respond to a change in price, the market price would not be as high as the very short period price, viz.

As we have seen, the short-run normal price would be smaller than the very short period market price. The length of the long period is so long that in this period, the firm would be able to change the quantities used of the fixed factors along with those of the variable factors to produce a larger or a smaller quantity of output.

We have already seen what is meant by long run or long period in our discussion of the theories of production and cost. 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.

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.

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. It is truly a balance of the market components. To understand why the balance must occur, examine what happens when there is no balance, such as when market price is below that shown as P in Image 1. At any price below P, the quantity demanded is greater than the quantity supplied. In such a situation, consumers would clamour for a product that producers would not be willing to supply; a shortage would exist.

In this event, consumers would choose to pay a higher price in order to get the product they want, while producers would be encouraged by a higher price to bring more of the product onto the market. The end result is a rise in price, to P, where supply and demand are in balance. Similarly, if a price above P were chosen arbitrarily, the market would be in surplus with too much supply relative to demand. If that were to happen, producers would be willing to take a lower price in order to sell, and consumers would be induced by lower prices to increase their purchases.

Only when the price falls would balance be restored. A market price is not necessarily a fair price, it is merely an outcome. It does not guarantee total satisfaction on the part of buyer and seller. Typically, some assumptions about the behaviour of buyers and sellers are made, which add a sense of reason to a market price. For example, buyers are expected to be self-interested and, although they may not have perfect knowledge, at least they will try to look out for their own interests.

Meanwhile, sellers are considered to be profit maximizers. This assumption limits their willingness to sell to within a price range, high to low, where they can stay in business. When either demand or supply shifts, the equilibrium price will change. The section on understanding supply factors explains why a market component may move.

The examples below show what happens to price when supply or demand shifts occur. When a bumper crop develops, supply shifts outward and downward, shown as S2 in Image 2, more product is available over the full range of prices. With no immediate change in consumers' willingness to buy crops, there is a movement along the demand curve to a new equilibrium.

Consumers will buy more but only at a lower price. How much the price must fall to induce consumers to purchase the greater supply depends upon the elasticity of demand. In Image 2, price falls from P1 to P2 if a bumper crop is produced.

If the demand curve in this example was more vertical more inelastic , the price-quantity adjustments needed to bring about a new equilibrium between demand and the new supply would be different. To understand how elasticity of demand affects the size of adjustment in prices and quantities when supply shifts, try drawing the demand curve or line with a slope more vertical than that depicted in Image 2. Then compare the size of price-quantity changes in this with the first situation.

With the same shift in supply, equilibrium change in price is larger when demand is inelastic than when demand is more elastic.