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Determination of Equilibrium Price and Quantity Under Perfect Competition

Updated on June 1, 2014

A market in which all the buyers and all the sellers are price takers is called a perfectly competitive market. Price is determined by the industry. An industry is a collection of firms producing identical goods. The equilibrium price is determined at a point where the demand for and the supply of the total industry are equal. To put it in other words, at the equilibrium price, what the buyers are willing to purchase is exactly matched by what the sellers are willing to offer at that price. Quantity demanded and quantity supplied at the equilibrium price is known as the equilibrium quantity.

Table 1: Demand, Supply, the Equilibrium Price and the Output

Price (in $)
Quantity demanded
Quantity supplied
Direction of change in price
1
60
0
2
50
20
3
40
40
Equilibrium price
Equilibrium quantity
Equilibrium quantity
Equilibrium
4
30
60
5
20
80

Table 1 shows how the forces of demand and supply determine price. When the price is $1, 60 units are demanded but no supply is forthcoming. With the rise in price, demand falls and supply increases. When the price is $2, the demand is 50 units but the supply is only 20 units. Demand is more than supply at this price and so, the price of the product rises from $2 to $3. As a result, demand falls to 40 and supply increases to 40. Both the buyers and sellers are satisfied with this price. Thus, $3 is the equilibrium market price at which the demand for and the supply of the product is 40 units. If price is increased still further, say to $4, it increases the supply of goods to 60 units, but the demand is reduced to 30. Likewise, if the price increases still further, say to $5 demand will fall to 20 but supply will increase to 80 units. Thus, at the equilibrium market price and output, quantity demanded (Qd) equals quantity supplied (Qs). If Qs > Qd, the price tends to fall. If Qs < Qd, price tends to rise.

Graphic Illustration

Demand and supply curves can be used to analyze the equilibrium market price and equilibrium output.

Source

In figure 1, quantity is shown along the X-axis and price along the Y-axis. The market equilibrium E is established at the point of intersection of the demand and supply curves. By drawing a perpendicular from the equilibrium point to the X-axis we get the equilibrium quantity demanded and supplied, i.e., OQ. Likewise, by drawing a perpendicular to the Y-axis from the point of equilibrium we get the market price (OP).

Table 2: Market Equilibrium

Market Condition
Relationship between quantity demanded and supplied
Market Price
Equilibrium
Quantity demanded = Quantity supplied
In Equilibrium
Shortage
Quantity demanded > Quantity supplied
Rises
Surplus
Quantity demanded < Quantity supplied
Falls

Importance of Time Element in Price Theory

According to Marshall, the price of a commodity is determined by both demand and supply. He stresses the importance of time element in the determination of price. Before Marshall, there was a controversy regarding the relative importance of demand and supply in the determination of price. Marshall resolved this controversy with the introduction of the time element in his theory of value. In his view, the answer to the question as to which one is more important depends upon the time under consideration. He quoted the analogy of two blades of a pair of scissors in this connection. Just as both the blades are needed to cut a piece of cloth, both demand and supply are equally essential in the determination of price.

However, “as a general rule” Marshall said “the shorter the period which one considers, the greater must be the share of our attention which is given to the influence of demand on value; and the longer the period, the more importance will be the influence of cost of production on value.”

Marshall distinguishes four periods in which the equilibrium between demand and supply is sought:

1. The market period

2. The short period

3. The long period

4. The secular period

Distinction between Normal Price and Market Price

Market Price

1. it is a very short period price.

2. Supply curve is vertical.

3. It is influenced more by demand factors.

4. All goods have a market price.

5. Market price may be higher or lower than the cost of production.

6. A firm with a market price can earn super normal profits or incur losses.

7. Market price is a reality.

8. There will be a temporary equilibrium between demand and supply.

9. Market price fluctuates frequently (even daily).

Normal Price

1. It is a long period price.

2. Supply curve is horizontal.

3. It is influenced more by supply factors and the cost of production.

4. Only reproducible goods alone have a normal price.

5. Normal price is equal to the cost of production.

6. A firm with a normal price can earn only normal profits.

7. Normal price is a mirage.

8. There will be a permanent equilibrium between demand and supply.

9. Normal price is relatively stable.

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