Introductory Economics

Price Determination

Under perfect competition price of a commodity is not determined by any individual seller or a firm. It is, determined ermined by the forces of market supply and market demand for a commodity.
In other words Equilibrium price of a commodity is determined at that point where the market demand equals market supply. It can be explained with the help of the table as well figure given below.

Market supply	Price per unit	Market demand
50	5	10
40	4	20
30	3	30
20	2	40
10	1	50

Table 1. shows that when price of good-X is Rs.5.00 per dozen, its supply is of 50 dozens and demand is for 10 dozens. Since supply is more than demand, there will be competition among the sellers of good-X. Due to this competition, price of good-X will fall. Fall in price will contract supply but extend demand. When price falls to Rs. 3.00 per dozen, then the demand becomes equal to supply. Thus Rs 3 per dozen is the equilibrium price of good X. If due to certain reasons price falls to Rs 2 then demand will be more than supply. It will lead to competition among buyers. As a result, price will begin to rise till it reaches Rs. 3.00 per dozen. At this price once again equilibrium between demand and supply will be established

• In Fig units of good-X are shown on OX-axis and price on OY- axis. DD is the total demand curve. It slopes downward from left to right. SS is the supply curve of industry. It slopes upward from left to right. Supply curve (SS) and demand curve (DD) intersect each other at point E.
• In other words, supply and demand are equal (30 dozens) at point E. Thus, Rs. 3.00 will be the equilibrium price and equilibrium quantity is 30 dozens. If price rises to Rs. 5 then, supply (50 dozen) will become more than the demand (10 dozen). It is clear from the diagram that at Rs. 5 the excess supply is equal to AB. In this situation supply being more than demand, there will be a tendency for the price to fall and it will revert back to equilibrium price of Rs. 3.
• In case price falls to Rs. 2, then supply (20 dozens) will be less than demand (40 dozens) Demand being more than supply, there will be a tendency for the price to rise. CD represents shortage in the figure. This shortage o r excess demand will push the price back to equilibrium level i.e. Rs.3.

• Fig. 1 indicates that price of good-X is determined by the industry at that point where demand is equal to supply. Price of the good, under perfect competition is, therefore, determined by the industry and each firm has to sell its product at this very price. It is shown by Fig. 2 (A) and 2 (B).
• In Fig. 2(A) market demand curve DD intersects market supply curve SS at point E. Thus, point E is the equilibrium point and OP is the equilibrium price. Fig. 2(B) refers to firm’s demand curve. The firm will have to sell all its output at the prevailing price OP. It may sell more units or fewer units, but it will charge OP price only. The firm can neither increase nor decrease this price, because price is determined by the industry and not by the firm. Firm is a price-taker and not price-maker. As such, firm’s demand curve (PP) will be parallel to X-axis, signifying that the firm can sell any number of units at OP price. Firm’s demand curve PP is also its average revenue and marginal revenue curve. Under conditions of perfect competition AR = MR (as AR is constant for a firm) and their curves coincide with each other.