Question

How is the price of a commodity determined under Perfect Competition ? Explain with the help of an example and diagram.

Hint:

Remember that in perfect competition, the \textbf{industry} is the price maker, and the \textbf{firm} is the price taker. Use both a schedule and a diagram to clearly illustrate how the interaction of demand and supply determines the equilibrium price, and how surpluses and shortages are automatically corrected by market forces.

Answer 1

In a perfectly competitive market, the price of a commodity is determined by the collective forces of market demand and market supply. No individual firm or buyer can influence the price; they are "price takers." The price is set at the equilibrium point where the total quantity demanded by all consumers equals the total quantity supplied by all producers in the industry.

Determination of Equilibrium Price:

• Market Demand: It is the sum of the quantities demanded by all buyers at different prices. The market demand curve is downward sloping, indicating that consumers will buy more at a lower price.
• Market Supply: It is the sum of the quantities supplied by all firms at different prices. The market supply curve is upward sloping, indicating that producers will sell more at a higher price.

The equilibrium price is established where the market demand curve intersects the market supply curve. At this point, there is neither a shortage nor a surplus of the commodity in the market.

Example with a Schedule:

Let’s consider a hypothetical market for wheat. The following schedule shows the quantity demanded and supplied at various prices.

Price per kg ($)	Quantity Demanded (kg)	Quantity Supplied (kg)	Market Situation
5	1,000	5,000	Excess Supply (Surplus)
4	2,000	4,000	Excess Supply (Surplus)
3	3,000	3,000	Equilibrium
2	4,000	2,000	Excess Demand (Shortage)
1	5,000	1,000	Excess Demand (Shortage)

Explanation:

• At a price of $5, suppliers are willing to sell 5,000 kg, but consumers only want to buy 1,000 kg. This surplus of 4,000 kg will force producers to lower their prices to sell their stock.
• At a price of $1, consumers want to buy 5,000 kg, but suppliers are only willing to sell 1,000 kg. This excess demand will force producers to raise their prices to sell more.

Explanation with a Diagram:

In the diagram, the market demand curve (DD) and market supply curve (SS) intersect at point E. This is the equilibrium point. The price corresponding to this point is P∗, and the quantity is Q∗. At any price above P∗ (like P1), there is excess supply, which pushes the price down. At any price below P∗ (like P2), there is excess demand, which pushes the price up. Thus, the market naturally gravitates towards the equilibrium price P∗