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Determination of Prices

Price Determination under Perfect Competition

Under perfect competition, many factors influence the determination of the price of goods. In this article, we will look at the equilibrium of the industry and the equilibrium of a firm as important factors behind price determination under perfect competition.

Equilibrium of the Industry under Perfect Competition

In economic terms, an industry consists of many independent firms. Each firm has a number of factories, farms or mines, as required. Each such firm in industry produces a homogeneous product. Equilibrium of the industry happens when the total output of the industry is equal to the total demand. In such a scenario, the prevailing price of a commodity is its equilibrium price.

We know that under competitive conditions, the interaction of demand and supply determines the equilibrium price as shown below:

perfect competition

In Fig. 1 above, OP is the equilibrium price. Further, OQ is the equilibrium quantity sold at that price. Now, the equilibrium price is the price at which both the demand and supply are equal. In other words, no buyer, who wanted to buy at that price, goes dissatisfied and no seller, who wanted to sell his goods at that price, goes dissatisfied either.

Note that with the demand remaining the same, if the price is higher or lower than OP, then the market is not in equilibrium. Also, if goods are lesser or higher than the demand, the equilibrium is not attained.

Browse more Topics under Determination Of Prices

  • Intro to Determination of Prices
  • Changes in Demand
  • Changes in Supply
  • Simultaneous changes in Demand and Supply
  • Features of Perfect Competition
  • Long Run Equilibrium of Competitive Firm and Industry
  • Monopoly Market
  • Monopolist’s Revenue Curve
  • Price Discrimination
  • Monopolistic Competition
  • Oligopoly
  • Kinked Demand Curve

Equilibrium of the Firm under Perfect Competition

A firm is in equilibrium when it maximizes its profits. Hence, the output that offers maximum profit to a firm is the equilibrium output. When a firm is in equilibrium, there is no reason to increase or decrease the output.

In a competitive market, firms are price-takers. The reason being the presence of a large number of firms who produce homogeneous products. Therefore, firms cannot influence the price in their individual capacities. They have to follow the price determined by the industry.

The following figure shows a firm’s demand curve under perfect competition:

perfect competition

From Fig. 2 above, you can see that the industry price, OP, is fixed throughout the interaction of demand and supply of the industry. Firms have to accept this price. Hence, they are price-takers and not price-makers. Hence, they cannot increase or decrease the price OP.

Therefore, the line P acts as a demand curve for such firms. Hence, in perfect competition, the demand curve of an individual firm is a horizontal line at the level of the industry-set market price. Firms have to choose the level of output that yields maximum profit.

Conditions for the equilibrium of a firm

To attain an equilibrium position, a firm must satisfy the following two conditions:

They must ensure that the marginal revenue is equal to the marginal cost (MR = MC).

  • If MR > MC, the firm has an incentive to expand its production and sell additional units.
  • If MR < MC, the firm must reduce the output since additional units add more cost than revenue.
  • The firm gets maximum profits only when MR = MC.
  1. The MC curve must have a positive slope and cut the MR curve from below.

perfect competition

In Fig. 3 above, DD is the demand curve and SS is the supply curve. They equilibrate at point E and set the market price as OP. Under perfect competition, firms adopt OP as the industry price and consider the P-line as the demand curve or AR – average revenue curve (perfectly elastic at P).

Since all units are equally priced, the MR curve is a horizontal line and is equal to the AR line. Observe that the curve MC cuts the MR curve at two points – T and R. At point T, the MC curve cuts the MR curve from above whereas at point R it cuts the MR curve from below. Therefore, according to the conditions of equilibrium of a firm, point R is the point of equilibrium and OQ2 is the equilibrium level of output.

Solved Question on Perfect Competition

Q1. What is the shape of the demand curve faced by a firm under perfect competition?

  1. Horizontal
  2. Vertical
  3. Positively sloped
  4. Negatively sloped

Answer: Under perfect competition, a firm accepts the price set by the industry. Hence, the fixed-price-line acts as a demand curve for the firms – which is horizontal. Therefore, the correct answer is – Option a-Horizontal.

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