Useful Notes on Equilibrium Price Under Perfect Competition

There was a dispute among earlier economists who came before Marshall as to whether it is supply of a good or the demand for it that determines its price. Broadly speaking, there were two schools of thought in this regard.

One school of thought includes classical economists like Adam Smith, Ricardo, J. S. Mill and some social thinkers like Marx, Sismondi and Robert Owen. According to this school of thought, it is the cost of production or supply of goods which determine the price.

In fact, there was a controversy between two schools of thought with regards to determination of equilibrium price under perfect competition. One school of thought argued that, it is supply which plays a crucial role for determining price and other school of thought argued that, it is demand which plays a crucial role for determining price under the perfect competition.

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Thanks to Marshall who solved this controversy. He synthesised the two approaches of two schools of thought. According to Marshall it is not demand alone or supply alone can determine the price under perfect competition.

Both demand and supply play equally important role for determining the price under perfect competition. Both demand and supply play equally important role for determining the price under perfect competition.

He compared price determination with the act of cutting a piece of paper with two blades of a scissor. The cutting is done neither by the upper blade nor by the lower blade alone.

Both blades are equally important for cutting a piece of paper. In the similar way, both demand for product and supply of product have equally important for determining price under perfect competition.

Therefore, according to Marshall, under perfect competition price is determined by both the forces of demand and supply. One is not less important than other.

Only they may be more or less active depending on the time period under consideration. Shorter the time period under consideration, greater the influence of demand and longer is the time period, greater is the influence of supply in the determination of price.

Below we discuss both demand and supply side for determination of equilibrium price.

The demand side:

From the demand theorem we know more quantities of good are demanded at less price and vice-versa, other things remaining constant.

We also know that, the individual demand schedule is the list of different possible prices and quantities of a commodity and the market demand schedule is the addition of the individual demand schedules.

The market demand curve is a graphical representation of market demand schedule. The market demand schedule is shown in the table 2.8 and market demand curve is shown in fig. 2.23.

The market demand schedule is shows on the table 2.8 and demand curve is shown in fig. 2.23. Here, market demand curve DD₁ is drawn on the basis of market demand schedule shown in table-2.8. DD is negatively sloped.

The Supply side:

We know from the law of supply that the individual supply curve slopes upward to the right as there is positive relationship between price and quantity supplied.

Like individual demand curve, the industry determines the market supply curve by horizontally adding the supply curve of all sellers present in the market. The market supply schedule and market supply curve is shown in Table 2.9 and 2.24 respectively.

From the table 2.9 we know that when price increases the supply also increases. By plotting all the combination points of price and quantity we get an upward slopping market supply curves SS₁.

Equilibrium Price Determination:

In order to determine the equilibrium price under perfect competition we have to make together both market demand schedule and market supply schedule as well as both market demand curve and market supply curve of an industry together.

Table 2.10 Market demand and supply schedule of orange:

It is seen from table 2.10 that when prices are Rs. 10/- and 20/- per kg the demand is more than supply, so that price tends to rise. When prices are Rs. 40/- and 50/- per kg the quantity supplied is more than the quantity demanded, so that price will fall.

It is only at price Rs. 30/- both quantity demanded and quantities supplied are equal. The equilibrium price is Rs. 30/- and equilibrium quantity is 300 kg of orange.

The determination of equilibrium price can also be shown with the help of a diagram. This is shown in fig. 2.25.

In fig. 2.27 the demand curve DD, intersects the supply curve SS, at point E. At this point the price is Rs. 30/- and the quantity demanded and supplied is 300 kg. Since quantity demand equals supply at this price, this is equilibrium price. When the market price is Rs. 10/- there is ‘excess of demand’ of MN quantity.

So prices rise where it reaches the point at E (Rs. 30). Similarly, when price is Rs. 50/0, there is “excess supply” of amount ‘TS’ which causes prices to full till it reaches at point E (Rs. 30). Therefore, equilibrium price is Rs. 30/- when demand and supply are at balance.

Change in Demand and supply and Equilibrium price:

The equilibrium price and quantity will change as a result of change in demand or change in supply or both.

(a) Change in demand and equilibrium Price:

If there is increase or decrease in demand, the demand curve will be shift to right and left respectively.

In the above figure 2.26, the original demand curve is DD and original supply curve is SS. So that original equilibrium price is OP and original equilibrium quantity is OQ. Suppose, supply remaining constant and there is increase in demand leading to upward shift in demand curve from DD to

D, D, Now the new equilibrium point is E, and price increases from OP to OP, and the quantity from OQ to OQ. On the other hand, suppose there is decrease in demand leading to shift of demand curve from DD to D, D, Here the equilibrium point is E, and price decreases from OP to OP₂ and the quantity from OQ to OQ,. Thus, supply remaining unchanged, when demand increases price rises and when demand decreases price falls. This is the impact of change in demand on price.

(b) Change in supply and equilibrium Price:

Now we will examine what will happens to the equilibrium price and quantity, when supply changes keeping demand constant.

In fig. 2.27, E is the point of initial equilibrium where original demand curve DD and original supply curve SS intersect each other. OP is the equilibrium price and OQ is the equilibrium quantity.

If supply increases from SS to S’S’, price decreases from OP to OP, and quantity increases from OQ to OQ, On the other hand, if supply decreases from SS to S₂S₂, the price increases from OP to OP, and quantity decreases from OQ to OQ.

Therefore, it is seen from the diagram that when supply increases, price falls and when supply decreases, price rises, demand remaining unchanged. This is the impact of change in supply on price.

(c) Change in both demand and supply and equilibrium Price:

If both demand and supply change simultaneously there would be change in equilibrium price and quantity.

In fig. 2.28, DD is the original demand and SS is the original supply. OP is the original price and OQ is the original quantity.

Now with the increase in both demand and supply price the price increases OP to OP₁ because, here, the percentage increase in demand is more the percentage increase in supply.

Fig. 2.29 is just opposite of fig. 2.30. Here both demand and supply increases and percentage increase in supply is more than percentage increase in demand, so that price falls from OP to OP₁.

In fig. 2.30 the percentage increase in demand is equal to percentage increase in supply, so that price remains constant at OP and quantity increases from OQ to OQ₁.