Competition is a fundamental aspect of market economies, where multiple buyers and sellers interact to exchange goods and services. In a perfectly competitive market, certain features and mechanisms determine the price. Let’s explore them:
Features of Perfect Competition:
- Large Number of Buyers and Sellers: There are numerous buyers and sellers in the market, with no individual firm having a significant market share or control over the market price.
- Homogeneous Products: Firms in a perfectly competitive market produce and sell identical or homogeneous products. This means that buyers perceive the products of different firms as perfect substitutes.
- Price Taker: Each individual firm in a perfectly competitive market is a price taker, meaning it has no control over the market price. The market price is determined by the overall interaction of demand and supply in the market.
- Perfect Information: Buyers and sellers have perfect and complete information about the market, including product prices, quality, availability, and other relevant factors. There are no informational barriers or information asymmetry.
Determination of Price under Perfect Competition: In a perfectly competitive market, the price is determined by the interaction of demand and supply. Here’s how it happens:
- Demand: The demand curve represents the willingness and ability of buyers to purchase a product at different prices. Under perfect competition, individual firms face a perfectly elastic demand curve, meaning they can sell any quantity at the prevailing market price. This is because buyers perceive the products of all firms as identical and have perfect information about prices.
- Supply: The supply curve represents the quantity of a product that firms are willing and able to produce and sell at different prices. In perfect competition, individual firm’s supply curves are typically upward sloping, indicating that as the price increases, firms are willing to produce and sell more.
- Equilibrium Price: The equilibrium price in a perfectly competitive market is determined at the point where the demand and supply curves intersect. This is the price at which the quantity demanded equals the quantity supplied, ensuring market equilibrium.
- Price Taking Behavior: Individual firms in perfect competition have no influence over the market price. They must accept the prevailing market price as given and adjust their output levels accordingly. If a firm tries to set a higher price, buyers will shift their demand to other firms offering the same product at a lower price.
- Zero Economic Profits in the Long Run: In the long run, under perfect competition, firms earn only normal profits, where total revenue equals total costs. If firms in the industry are making above-normal profits, new firms will enter the market, increasing supply and causing the price to decrease. Conversely, if firms are making losses, some firms will exit the market, reducing supply and causing the price to increase.