Price determination under perfect competition

Price determination under perfect competition

Perfect competition is a comprehensive term which includes the following conditions:

  1. Free entry and exit of firms
  2. Existence of a large numbers of buyers and sellers
  3. Commodity supplied by each firm is homogeneous
  4. Existence of single price in the market

Under this condition, no individual firm will be in the position to influence the market price of the product.
According to Bilas, “The perfect competition is characterised by the presence of many firms; they all sell the same product which is identical. The seller is the price- taker”

Features of perfect competition-
  • Existence of a large number of buyers and sellers
  • Absence of government controls
  • Homogenous products
  • Normal profits
  • Free entry and exit of firms
  • Existence of single price
  • Perfect knowledge of the market
  • Perfect mobility of factors of production
  • The market price is flexible over a period of time
  • Full and unrestricted competition
  • It is an ideal market situation
  • It is a rare phenomenon which does not exist in reality

Price-Output Determination under perfect competition
There are two well known approaches to pricing under perfect competition:

  1. Partial Equilibrium Approach
  2. General Equilibrium Approach

1- Partial Equilibrium Approach:- In this approach we assume that the prices of various commodities are independent and do not mutually affect one another. This approach isolates the primary relation of supply, demand and price in regard to a particular commodity. Thus in this approach to pricing under perfect competition, demand for a commodity is determined on the assumption that the prices of the other commodities, prices of factors and production function remain the same.

According to Prof. Lipsey,”All partial equilibrium analyses are based on the assumption of ceteris paribus. Strictly interpreted, the assumption is that all other things in the economy are unaffected by any changes in the sector under consideration (say sector A). This assumption is always violated to some extent, for anything that happens in one sector must cause changes in some other sector. What matters is that the changes induced throughout the rest of the economy are sufficiently small and diffused so that the effect they in turn have on the sector A can be safely ignored.”
Thus the partial equilibrium analysis discusses only the price determination of a commodity in isolation and does not explain how the prices of various commodities are inter-dependent and inter-related.

2- General Equilibrium Approach: this approach does not assume that the prices of a good are determined independently of the prices of other goods. It explains the mutual and simultaneous determination of the prices of all goods and factors. Thus it looks at multi-market equilibrium.
In the case of the inter-related goods, we have to resort to a general equilibrium approach. According to Stonier and Hague, “if X and Y are either strongly complementary or strongly competitive, a fall in the price of X can have a substantial effect on the demand for Y. General Equilibrium analysis attempts to take account of such relationship.”
Price Determination-General Statement: There was confliction between various economists in the determination of the value or price. Few economists were in favour of the force of demand while other was in favour of the force of supply.
Marshall solved out this dispute while comparing supply and demand to the blades of the scissor. Just as both the blades work together to cut a piece of cloth, both supply and demand interact with each other to determine the market price at which exchange takes place. Both forces play an equally important role.
Equilibrium price: A demand curve normally slopes downwards which means that, other things remaining the same, more quantity of a commodity will be demanded at a lower price. A supply curve normally slopes upwards. It means that the producers will offer to sell larger quantity of the product at a higher price. Supply depends on the number and size of the firms, production techniques and the prices of the productive resources.

Table Price-Determination Based on Demand and Supply
Demand (in units)
Price(in rupee)
Supply (in units)
10
500
50
20
400
40
30
300
30
40
200
20
50
100
10
Equilibrium price will be Rs.300 where the Demand and Supply are equal i.e. 30 units.



The price at which demand and supply are equal is known as equilibrium price and the quantity bought and sold at the equilibrium price is known as equilibrium output.
In the diagram, equilibrium price is determined at the point P where both demand and supply are equal. The upper limit of the price of a product is determined by the demand. The lower limit of the price is determined by the production cost. The point P can be regarded as the position of stable equilibrium.

Under perfect competition,a firm will not have any independence to fix the price of its own product. The industry is the price –maker and the firm is the price-taker.

In case of a firm, the price line which is equal to AR and MR, will be horizontal and parallel to OX axis. It shows that the same price has to be charged by the firm for all units supplied, irrespective of changes in demand.

Equilibrium or market price = AR =MR

At the equilibrium point, an economic unit is maximising its benefits or advantages.
In the short run, an industry reaches  the equilibrium position when the following condition are fullfilled-

1 There is no scope for the new  firms to enter or exit the industry.
2 Short run demand should be equal to the short term supply. Hence, short-term price is not a stable price.
3 There is no scope for expansion or contraction of the output in the   entire industry. The total output remains constant in the short run at the equilibrium point where MR=MC.
In the long run, industry has the sufficient time to make all kinds of changes, adjustments  and readjustments in the production process.All the input becomes variable in the long run and the production can be either increased or decreased according to the demand as a whole.

In the long-run, an industry will reach to the position of equilibrium under the following conditions-
1 At the equilibrium price,the long run demand and supply of the products of the industry must be equal to each other and it will determine the long run normal price.
2 All the firms in the industry should also be in the equilibrium position where MC=MR and AC=AR. All the firms should  earn only normal profits and this will help the industry to attain a stable equilibrium in the long run.
3 The total number of firms in the industry should remain constant.


Equilibrium of the firm under perfect competition
In short run:-in the short run, the firm will have temporary equilibrium where MR=MC and AR=AC. At this point,equilibrium output and price is determined. The short run price is called as a sub-normal price and it is not a stable price.
In the short run, firm will not be in the position to cover its fixed costs but it must recover short run variable costs for its survival in the market. Short run price should be at least equal to the minimum AVC


Firm is a price-taker. If the price is more than AC, then the firm will attain supernormal profit. In this situation, MC=MR but AC<AR.



if AC is equal to price, then firm will attain normal profit. In this condition AC=MC=AR=MR=P



  

If AC is greater than price, there will be losses. In this situation, MC=MR but AC>AR

Thus, in short run, a firm can either incur losses or earn supernormal profit or normal profit.
The main reason for this is that the firm does not get adequate time to make all kinds of adjustments to avoid losses in the short run.

In long run, a firm will attain only normal profit where P=AR=AC=MR=MC.
If AR is greater than AC, then the firm will earn supernatural profit and it will lead to the entry of new firms, as a result, increase in the total number of the firms and finally increase in supply and fall in price and ratio of profits. This process will continue till supernatural profits are reduced to zero. On the other hand, if AR is less than AC, loss will occur and this will lead to the exit of old firms, decrease in the number of the firms, decrease in supply and rise in price and finally the rise in the ratio of profits. Such process will continue until the firm reaches to the equilibrium position where AC =AR.
Long run equilibrium will be where LMC=LMR=LAC=LAR=P


In the long run, a competitive firm must be at the minimum point of the LAC curve to avoid losses.
In short run, demand plays an important role in the determination of price while in long run, supply is more important than demand in determination of price.