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PRICING IN COMPETITIVE MARKETS
Some markets, such as those for agricultural commodities and
gasoline, seem to have just one price at any given time. All producers
in the market charge the same or very similar prices. Typically, with
many firms selling essentially the same product, these markets are
highly competitive.
In highly competitive markets, the collective actions of many buyers
and sellers drive the price of goods and the total quantity of goods
that firms produce.
This topic looks first at an overall market equilibrium and then
considers the output decisions of individual firms operating in
competitive markets.
A competitive market is in equilibrium if, at the current market price,
the number of units that consumers wish to buy equals the number of
units producers wish to sell. In other words, market equilibrium occurs
where quantity demanded equals quantity supplied. At the equilibrium
price, P*, the equilibrium quantity is Qd=Qs=Q*, where Qd is the
quantity demanded and Qs is the quantity supplied. The asterisk
indicates equilibrium.
You can show an equilibrium market price on a graph by plotting
supply and demand curves on a single set of axes. When you look at
the graph below, notice that equilibrium price and quantity occur at
the point where the demand and supply curves cross. P* and Q*
indicate equilibrium price and quantity, respectively.
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Excess Demand
Excess demand occurs when the current market price is below the
equilibrium price (P*). With excess demand, consumers want to
purchase more units of a good than producers want to sell. When price
is below equilibrium and the product sells out quickly, competition
among consumers, along with recognition by producers that they could
raise price and still sell all units, leads to upward pressure on prices.
On a graph, you can show excess demand as the horizontal distance
between the demand and the supply curves at a price below the
equilibrium price. Looking at the graph below, notice that the current
market price, P1, is below the equilibrium price, P*. You can see that
at P1 the quantity demanded, Qd, is much greater than the quantity
supplied, Qs. The difference between Qs and Qd is excess demand.
Excess Supply
Excess supply occurs when the current market price is above
equilibrium. With excess supply, producers cannot sell as much of their
product as they would like at that price. Competition among producers
to increase sales leads to downward pressure on prices.
You can show excess supply on a graph as the horizontal distance
between the demand and the supply curves at a price above the
equilibrium price. Looking at the graph below, notice that the current
market price, P2, is above the equilibrium price, P*. You can see that
at P2 the quantity supplied, Qs, is much greater than the quantity
demanded, Qd. The difference between Qd and Qs is excess supply.
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It should be noted that only at the equilibrium price does the quantity
demanded equal the quantity supplied.
Changes in Market Equilibrium
The 1990s brought a dramatic increase in the demand for personal
computers. Despite this increase, computer prices have been steadily
declining, even as the quality and capabilities of all computers have
increased. Would a simple supply-and-demand model have predicted
this result? To answer this question, first consider a graphical approach
to changes in supply and demand and their effects on the equilibrium
price and quantity in a market.
The model of supply and demand is useful for explaining movements
in market prices and sales when factors change the supply or the
demand for a good. The primary factors that may cause a change in
demand, or a shift in the demand curve are
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consumer income
prices of related goods
advertising and consumer preferences
population
expectations
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The primary factors that may cause a change in supply, or a shift in
the supply curve, are
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input prices and taxes
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technology and government regulation
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profitability of substitutes in production
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number of firms
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expectations
The supply-and-demand diagram provides a useful and straightforward
method of performing general comparative statistical analysis for
competitive markets. You can use graphical diagrams to perform
comparative statics for other types of economic problems as well.
However, it is often convenient to show these effects using
mathematical models. Mathematical models allow you to be more
specific about the size of the changes, and they allow you to perform
comparative statics in situations for which the problem being
considered does not have a convenient graphical representation.
Comparative Statics - a Graphical Approach
How would a change in each of the primary factors affect the
equilibrium price and quantity sold in a competitive market? You can
answer this question by using a supply-and-demand diagram and by
determining whether a change in demand, a change in supply, or a
change in both has occurred.
Begin by considering a market that is initially in equilibrium.
Equilibrium is shown here where the supply and demand curves
intersect at P* and Q*.
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CHANGES IN DEMAND
Now consider how changes in demand affect equilibrium price and
quantity. An increase in demand corresponds to a rightward (or
upward) shift of the demand curve. An increase in demand for a good
can result from such events as an increase in consumer income, a
decrease in the price of a complement good, or an increase in the price
of a substitute good.
Increase in demand The two figures below illustrate an increase in
demand. Notice on the graphs that an increase in demand causes the
equilibrium price to increase from P1 to P2, and the equilibrium
quantity sold to increase from Q1 to Q2.
You can see that if supply is relatively elastic, as shown in the left
graph, an increase in demand leads to a relatively small increase in
the equilibrium price but a relatively large increase in quantity sold. In
the extreme case of a perfectly elastic (horizontal) supply curve, an
increase in demand causes no change in price; the equilibrium
quantity sold simply increases.
If supply is relatively inelastic, as shown in the right graph, the
increase in price is relatively large, and the increase in quantity sold is
relatively small. In the extreme case of a perfectly inelastic (vertical)
supply curve, an increase in demand causes no change in quantity
sold; the equilibrium price simply rises.
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Decrease in demand
A decrease in demand corresponds to a leftward (or downward) shift
of the demand curve. You can use the same two figures above to
illustrate a decrease in demand and the resulting effects on price and
quantity sold. Simply reinterpret Demand 2 as the initial demand
curve, and let Demand 1 represent the new level of demand. Notice on
the graphs that a decrease in demand causes the equilibrium price to
decrease from P2 to P1 and quantity sold to fall from Q2 to Q1. Also,
notice how the relative effects of a decrease in demand on price and
quantity sold depend on the elasticity of supply.
CHANGES IN SUPPLY
How do changes in supply affect equilibrium price and quantity? An
increase in supply corresponds to a rightward shift of the supply curve.
Factors that cause an increase in supply include a decrease in the
costs associated with producing a good or an increase in the number of
companies producing the good.
Increase in supply
The two figures below illustrate an increase in supply. Notice on the
graphs that an increase in supply causes the equilibrium price to fall,
from P1 to P2, but the equilibrium quantity sold to increase from Q1 to
Q2 .
If the demand for a good is relatively elastic, as shown in the left
graph, an increase in supply causes a relatively small decrease in price
and a relatively large increase in quantity sold. In the extreme case of
a perfectly elastic (horizontal) demand curve, an increase in supply
causes no change in price; the equilibrium quantity sold simply
increases.
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In the extreme case of a perfectly inelastic (vertical) demand curve, an
increase in supply causes no change in quantity sold; the equilibrium
price simply falls.
If demand is relatively inelastic as shown in the right graph, an
increase in supply leads to a relatively large decrease in the
equilibrium price, but a relatively small increase in quantity sold.
Decrease in supply. A decrease in supply corresponds to a leftward
shift of the supply curve. You can use the same two figures above to
illustrate a decrease in supply and the resulting effects on price and
quantity sold. Simply reinterpret Supply 2 as the initial supply curve,
and let Supply 1 represent the new level of supply. Now notice on the
graphs that a decrease in supply, from Supply 2 to Supply 1, causes
the equilibrium price to increase, from P2 to P1, but the equilibrium
quantity to fall, from Q2 to Q1. Also, notice how the relative effects of a
decrease in supply on price and quantity sold depend on the elasticity
of demand.