How is price determined under perfect competition?



There was a controversy among earlier economists as to whether the supply of a good or the demand for it goes to determine price of a commodity under perfect competition. Some were of the opinion that it is the marginal utility on the side of demand determines price. Others held that it is the cost of production i.e. the marginal cost on the side of supply determines price. But both of them took one-sided view of the pricing problem.

It was Marshall who gave equal importance to both the forces of demand and supply in determining price and output under perfect competition. He said that both the marginal utility and marginal cost took part in determining price. He compared price determination with the act of cutting with a pair of scissors.

Both the blades are necessary for cutting a piece of paper although the lower blade acts, more in actively than the upper blade. No piece of paper can be cut by the help of individual blades. Thus the price under perfect competition is determined by the twin forces of market demand and market supply.

On the demand side it is buyers and on the supply side it is sellers who take part in the process of determining prize. The buyers are always willing to offer lower price and the sellers always like to sell at a high price. Transaction will be effective only when price is acceptable to both the opposite parties. For the better analysis of price determination the demand side and supply side are to be separately studied.

Demand side:

The demand curve of a commodity slopes downward. This expresses that with the rise in price quantity demanded rises and with the rise in price quantity, demanded falls. A consumer is always guided by the marginal utility in buying a particular commodity. When the quantity demanded of a commodity rises he will be prepared to pay less and less as the marginal utility of the commodity continues falling.

Thus the price of the commodity is paid accordingly. Below- is given the demand schedule of a commodity. Price and quantity of potatoes are measured along OY-axis and OX-axis respectively. 'DD' is the demand curve which slopes downward showing less is demanded at a higher price and more is demanded at a lower price. The demand curve DD' is drawn according to law of diminishing marginal utility.

Supply side

The supply curve of a commodity usually slopes upward. Law of supply holds that more of a commodity is supplied at high price and less of a commodity is supplied at a lower price. Supply depends on the cost of production. The price charged by a seller depends on the marginal cost of production. Because of the operation of the law of diminishing returns and larger quantities can be produced only at higher prices.

The above schedule can be expressed in terms of a supply curve. In the diagram given below 'SS' is the supply which slopes upward to the right showing that larger quantities of potatoes can be offered at higher price.

Equilibrium between demand and supply:

The twin forces of market demand and market supply determine price. The level of price at which demand and supply curves interact each other will finally prevail in the market. The price at which quantity demanded equals quantity supplied is called equilibrium price. The quantity of the good bought and sold at this price is called equilibrium price. Thus the interaction of demand and supply curves determines price-quantity equilibrium. At the equilibrium price the buyers and sellers are satisfied.

Any price at the price Rs 12 quantity demanded is 3 and quantity supplied is 15. When supply exceeds demand price falls. If the price is Rs 4 quantity demanded is 10 but the quantity supplied is 5 when demand is more in relation to supply price rises.

Thus the forces of demand and supply push up and down the price to a point at which demand and supply are balanced. The price at which demand and supply are equal is Rs 6 and it is called equilibrium price. The equilibrium price is one at which quantity demanded equals quantity supplied and there is no tendency for the price to rise or fall. There is neither surplus nor shortage of the commodity at the equilibrium price.

In the above figure quantity demanded and quantity supplied measured along OX-axis and price along O Y-axis. 'DD' is the demand curve and 'SS' is the supply curve. At the point P both clubman and supply are equal. Corresponding to this point the equilibrium price is Rs 6 and the equilibrium output is 7 kgs of potatoes.

At any other price for example Rs 12 and Rs 4 demand and supply are not equal. At price 12 surplus of goods arise because Hits sellers would not be able to sell all the quantity. At Rs 4 hot storage of goods arise because the sellers are unable to supply to fully adjust the increased demand. But at Rs 6 equilibrium there is neither a shortage nor a surplus of the commodity and as a result market is vacant.