Price determination under perfect market situation

 The interaction between these two forces of demand and supply determines the price in the market. It is not the demand and supply of the single buyer and firm respectively that determine the price but it is the demand of all the buyers taken together and the supply of all the firms taken together that determine the price by their interaction.

The price at which demand and supply are equal is known as an equilibrium price, since at this price the forces of demand and supply are balanced, or are in equilibrium. The quantity bought and sold (or

the amount supplied or demanded) at this equilibrium price is known as the equilibrium amount.

If the equality between quantity demanded and supplied does not hold for some price, buyers’ and sellers’ desires are divergent: either the amount demanded by buyers is more than that offered by sellers, or the amount offered for supply by sellers is greater than the amount demanded by buyers. In either case, the price will change so as to bring about equality between quantity demanded and quantity supplied.

Diagrammatic Representation. An example in terms of both schedules and curves will make the whole thing clear. The table given below gives the demand and supply schedules relating to a variety of cotton cloth, and in Fig below DD is the demand curve and SS is the supply curve. A glance at the table and the figure will show how the price is determined by demand and supply.

It will be seen that, when the price is Rs. 15 per metre, 12 million metres are supplied and 12 million metres are demanded; the quantity demanded is equal to the quantity supplied. Rs. 15 per metre, therefore, is the equilibrium price. Price is in equilibrium at Rs. 15 or price of Rs. 15 will persist in the market because at this level there is no tendency for it to rise or fall. Of course, this equilibrium price may not be reached at once. There may have to be an initial period of trial and error or oscillations around this equilibrium level before price finally settles down and supply balances demand.

Equilibrium of the Firm and Industry under Perfect Competition

It is essential to know the meaning of firm and industry before analysing the two. Firm is an organisation which produces and supplies goods that are demanded by the people with the goal of maximising its profits. Industry is a group of firms producing homogeneous products in a market.

Output Decisions of the firm-short run equilibrium

The interaction of demand and supply curves determines the market equilibrium price and output. A perfectly competitive firm can sell as large a quantity as it wishes, as long as it accepts the prevailing market price. Short run is the planning period during which the rate of output can be changed by intensive use of existing plant. The total curves approach and the marginal and average curves approach are used in the choice of profit maximizing level of output.

Total curves approach:

A firm is in equilibrium when it has no tendency to change its level of output i.e., the firm needs neither expansion nor contraction. In equilibrium, the firm maximizes its profits, which by definition is the difference between total revenue (TR) and total cost (TC). A perfectly competitive firm is in equilibrium

when it produces the output that maximizes the difference between TR and TC.

 

Fig: Determination of profit maximizing output in the short run, total curves approach

The profit maximizing or optimal output is determined where the vertical distance between TC and TR is the greatest.

Marginal curves approach:

A firm in perfect competition can sell any amount of goods without affecting the price. Hence the demand or average revenue (AR) curve is a horizontal line at the height of the market price. Any additional output can be sold at a given market price and hence marginal revenue is equal to the price. Hence in perfect completion, MR = AR = Price

 

Fig: Determination of profit maximizing output in the short run, marginal curves approach

Conditions of Equilibrium of firms in short-run:

A firm would be in equilibrium when the following two conditions are fulfilled:

1. MC = MR.

2. MC curve cuts MR curve from below.

Consider Fig. 8.1 in which price 0P is prevailing in the market. The marginal cost curve cuts the MR curve at two different points E0 and E1 and marginal cost and marginal revenue are equal at these two points. E0 cannot be the position of equilibrium since at E0 second condition of the firms' equilibrium is not satisfied.

The firm can increase its profits by increasing production beyond E0 because marginal revenue is greater than marginal cost. The firm will be in equilibrium at point E1 or output 0Q1 since at E1 marginal cost equals to marginal revenue as well as marginal cost curve cuts marginal revenue curve from below.

Long-run equilibrium of the firm:

The long-run is the planning period during which a firm can make more adjustments than in the short run. In the long run, the firm can adjust its plant capacity or its scale of operations. Hence all costs are variable in the long run. Firms must earn normal profits. If the price is more than the long-run average cost (LAC), the firms can earn supernormal profits. Attracted by these profits, new firms will enter the industry and supernormal profits will be competed anyway. If the price is less than LAC, firms incur losses and some of the firms leave the industry so that no firms earn more than normal profits.

The condition for a long-run equilibrium of the firm is that marginal cost equals the price and the long-run average cost.

LMC = LAC = Price

At equilibrium, the short-run marginal cost is equal to the long-run marginal cost and the short-run average cost is equal to the long-run average cost.

SMC = LMC = LAC = SAC = P = MR

Long-run equilibrium of the industry:

The industry is in long-run equilibrium when all firms are earning normal profits. Under these conditions, there is no entry or exit of firms in the industry. The firm is in equilibrium at the level of output where

LMC = SMC = P = MR

Shut down point: In the short run, a firm will continue to produce only if it covers variable costs. If it fails to cover the variable costs, it will close down the operations to minimize losses. The point at which the firm covers its variable costs is called the shutdown or closing down point. Hence the firm would like to close down

the operations if the price of the product is less than its AVC. However, if the price is greater than AVC but less than ATC or AC, then the firm would continue its production in the short run because the contribution of profits can be made to fixed costs.

Break-even point: The break-even point (BEP) in economics is the point at which total cost and total revenue are equal, i.e. "even". There is no net loss or gain. In short, all costs that must be paid are paid, and there is neither profit nor loss. It represents the sales amount in either unit (quantity) or revenue (sales) terms that are required to cover total costs, consisting of both fixed and variable costs to the company. Total profit at the break-even point is zero. It is only possible for a firm to pass the break-even point if the value of sales is higher than the variable cost per unit.