Economic Essay: How Prices Are Determined in Perfect Competitive Markets and Factors That Cause the Equilibrium to Change
Introduction
This paper will discuss precisely how to determine commodity prices in a perfectly competitive market. Also, I will give some examples of what factors will affect pricing and the impact of price changes. The first thing you have to understand is that in a perfectly competitive market, there are a lot of transactions, which means that there are a lot of purchasers and vendors in this market structure. So the market share of a single exchange is too small and has no effect on the whole market, so the market price will not be affected. But this does not mean that there is no relationship between the market price and the purchasers and the vendors. What really determines the market equilibrium price is the supply and demand relationship between the total market demand and the overall market supply. The equilibrium price is the price generated by an equilibrium between market demand and market supply.
How to determine the price in a perfectly competitive market
In a perfectly competitive market, the number of buyers and sellers is usually significant and substantial. They are in constant competition to buy and sell homogenous products. Such a demand is so large that each of the participants buys and sells such a small portion of the total quantity of goods and services in the market. As a consequence, none of its individuals has any significance on the process of its price determination (Ghosh, 2018). Therefore, in a perfectly competitive market, the equilibrium price of the product is determined through interactions between the market demand and the aggregate market supply. The equilibrium price is, therefore, the price at which the market demand is equal to the market supply.
First of all, it is very important to satisfy the price of both purchasers and vendors, because only in this way the supply and demand of both sides can be increased. Therefore, the market price needs to reach an equilibrium point, which is called the equilibrium price. For example, if the price of a mobile phone rises from 500 pounds to 1,000 pounds, the demand of buyers will decrease, which will lead to reduced supply, sales volume, and profit of sellers. Therefore, this reflects the importance of a balanced market price. (Refer to Figure 1)
According to this chart, it can be seen that only the equilibrium price can make both parties more satisfied with the transaction and create a higher volume. Thus it can be seen that the equilibrium price is directly related to the relationship between supply and demand. Thus, if the market price does not reach equilibrium, when the demand of the buyer will be less, the supply curve of the seller will also be higher, so that the seller will not be satisfied with their selling price and they will not be able to maximize the profit. On the other hand, if the market price is balanced, more benefits will be generated for both sides. Therefore, market demand and market supply are inseparable, which is obvious (Santos & D’Antone, 2014).
The intersection of demand and supply usually determines the equilibrium price and quantity. Here, a single change in supply or demand will change the equilibrium price, quantity, and sometimes both. For example, in this equilibrium, the price is $6 per unit of commodity, and the equilibrium quantity is 20 units. In an instance where the market price is above the equilibrium price and the quantity supplied is also greater, a surplus is created. Hence the market price will fall.
A practical example is where a producer has an excess inventory that cannot sell (Fchan, 2017). Once they lower the product price, the demand will rise until an equilibrium is reached. Therefore, surplus tends to drive the price down. In another instance, if the product is always out of stock, the producer will raise the price of the product until the equilibrium is reached. Therefore, shortages raise the price of products.
Factor That Cause Equilibrium Price to Change
- Change in Demand
Excess demand for a commodity tends to imply a shift of the demand curve to the right. It exerts upward pressure on the current equilibrium price to rise to a new equilibrium. The supply of x is assumed to be fixed, and only demand for x has increased, causing a shift in the demand curve for good x.
Therefore, a shift in demand at the same price means consumers would wish to buy more (Amadeo, 2019). It is caused by several reasons such as a good becoming more popular, the price of a substitute being increased, the price of a complement good decreased, a rise in income, and other seasonal factors. An example was in 2005 when mortgage rates were lowered. New customers wanting the service flooded the market.
A decrease in demand will be a reduction in the equilibrium price and the quantity of a particular good. It causes a decrease in demand, and it causes excess supply to develop at the original price. A decrease in demand shifts the demand curve to the left, and it reduces the price and output of the commodity.
The curve shifts to the left if less of the good or service is demanded at every price. It mostly happens during a recession, then the income of buyers drops. The buyers will tend to buy less of everything. An example is during the Mad cow disease; consumers preferred chicken over beef. Therefore, the demand quantity per price generally reduced due to demand dropping.
- Changes in Supply
A change in supply will cause the current equilibrium price to change in the opposite direction. An increase in supply will cause a reduction in the current equilibrium price and the equilibrium quantity of the good.
An increase in supply in the goods and services shifts the supply curve to the right, which tends to reduce price and increases the output. These changes are caused by factors such as prices of factors of production, prices of other goods, state of technology available at the moment, taxation policies, and expectation of change in price in the future. An example is during certain fruit seasons at its peak, such as oranges. The prices will reduce due to increased supply.
Also, a decrease in supply causes an increase in the equilibrium price and a decrease in the equilibrium quantity of the good. This creates a decrease in supply.
- The Entry and Exit of Firms
In a competitive market, businesses and firms may enter and leave with minimum effort. These firms may be attracted to the market due to several reasons but mostly because of the expectation of profit that they are willing to make from the market (Economics Online, 2020). It causes the market supply curve to move to the right. A market that exists where prices are rising provides the best opportunity for the investor. It also lowers prices and encourages firms to leave the market.
- Changes in Demand and Supply
If demand and supply tend to change in opposite directions, then the equilibrium price can be determined, but the change in equilibrium output cannot be determined. A decrease in the current demand and an increase in supply will be a drop in the equilibrium price. An increase in demand and decrease in supply will increase the equilibrium price. Also, if demand and supply both increase, there will be an increase in the equilibrium input. If both decrease, there will be a decrease in the equilibrium output.
Conclusion
As seen previously, price is determined in a perfectly competitive market through the constant interactions between supply and demand. The length of time obtained for adjustments will determine the amount of change in quantity supply, therefore, influencing the price. Hence time plays an important role in price determination. As seen in a perfect market, prices of commodities must fall to encourage additional quantity that is being demanded and reduce quantity until the surplus is eliminated. Should a shortage exist, the price must rise to entice additional supply and reduce the quantity that is demanded until the current shortage is eliminated. Also, when there is movement along the demand curve, it means the price is the only factor that is changing. It is also important to note that when the demand curve shifts, it indicates that other determinants, aside from the prices, have also changed.
References
Amadeo, K. (2019, December 13). The shift in the Demand Curve. The Balance. https://www.thebalance.com/shift-in-demand-curve-when-price-doesn-t-matter-3305720
Economics Online. (2020). Equilibrium, Consumers, and producer. https://www.economicsonline.co.uk/Competitive_markets/Market_equilibrium.html
Fchan. (2017). Market Equilibrium. fchan. https://staffwww.fullcoll.edu/fchan/Micro/1MKTEQUIL.htm#:~:text=If%20a%20surplus%20exist%2C%20price,until%20the%20shortage%20is%20eliminated
Ghosh, V. (2018). Price Determination in a Perfectly Competitive Market. Economic Discussion. https://www.economicsdiscussion.net/price/price-determination-price/price-determination-in-a-perfectly-competitive-market/23765
Gölgeci, I., Karakas, F., & Tatoglu, E. (2019). Understanding demand and supply paradoxes and their role in business-to-business firms. Industrial Marketing Management, 76, 169-180.