The market price and output are generally determined on the basis of consumer demand and market supply. In simpler words, the organisations and industry need to be in equilibrium at a price level in which the quantity of demand is the same as the quantity supplied. Generally, they make a maximum profit if the organisation and industry are in equilibrium.
The tricky part about the market price and output determination is that they can change under certain circumstances. For obvious reasons, the price and output determination under perfect competition is not going to be the same as the price and output determination under monopolistic competition.
How price and output are determined in perfect competition?
Perfect competition refers to a market situation where a great number of buyers and sellers deal in homogenous products. Interestingly, there are no legal, social, or technological obstructions on the entry or exit of organisations under perfect competition.
Furthermore, the sellers and buyers are fully aware of the current market price of a product in perfect competition. Due to this, they do not sell or buy at a higher rate. The same price prevails in the market under such circumstances.
Under perfect competition, the buyers and sellers can no longer influence the market price by increasing their purchases or reducing the output. The industry determines the market price of the products in perfect competition. In other words, the market price of products is determined by taking into account two factors of the market – demand and supply.
When it comes to the determination of the price of a commodity, both demand and supply of the item play a crucial role in the process. A sum of the quantity demanded by every organisation in the industry is referred to as market demand, while the sum of quantity supplied by individual organisations in the industry is referred to as market supply.
In perfect competition, the price of the product is defined at the point where the demand and supply curve intersect each other. This point of intersection is referred to as the equilibrium point, and the price is known as the equilibrium price. The following diagram will give you a better understanding of price and outcome determination in perfect competition.
In the aforementioned diagram, you can see that supply is more than the demand at the price OP1. So, the prices will fall down to OP. When the prices move to OP2, the demand becomes higher than the supply, raising the prices to OP. E is the equilibrium point in the diagram, where the equilibrium price is OP, and the equilibrium quantity is OQ.
How perfectly competitive firms make output decisions?
A perfectly competitive firm generally has only one crucial decision to make, which is – what quantity to produce. Since the market demand and supply determine the price for the output of a product, an organisation does not have the choice to decide the price it charges.
Basically, the price for products is already determined in the profit equation. This compels the perfectly competitive firms to sell all units at the same price. Also, these firms encounter a perfectly elastic demand curve for its product, given the fact that consumers are willing to buy any number of units from them at the market price.
Ultimately, when the prices for outputs and inputs in the market are fixed, a perfectly competitive firm needs to choose a certain quantity of production that will determine its total revenue, total costs as well as the level of profits.
Explain the price and output determination under perfect competition in the long run
The term "long run" refers to a period that is long enough to allow changes in the variable and the fixed factors. In other words, all the factors in the long run are variable and non-fixed. This allows the firms to change their output by increasing their fixed equipment. For instance, they can simply expand their old plants or replace them with new plants or perhaps add new plants.
Furthermore, new firms can enter the industry in the long run. And if they want, these firms can diminish their fixed equipment by letting them wear out without replacement in the long run, while the existing firm can leave the industry.
Practically, the long term equilibrium refers to a situation where the firms get a free and complete scope for adjustments to the economic forces. In the long run, factors like the long run average and the marginal cost curves are crucial for making output decisions. Interestingly, the average variable cost has no particular relevance in the long run. The average total cost, however, is of importance as all costs are variable in the long run.
In the short period, however, an organisation under perfect competition is in equilibrium at that output at which the marginal cost is the same as the marginal revenue. Interestingly, this is applicable for longer run as well. The twist is that the price must be equal to the average cost for a perfect competition firm to be in equilibrium in the longer run. If at all, the price is higher than the average cost, the firms will be making remarkable profits.
Now when there’s a remarkable profit, several new organisations enter the industry, hoping to reap the benefits of the same. However, the extra profit now goes through competition. With the entry of new firms in the industry, the supply or output of the industry is naturally going to increase. The new firms keep entering this industry, until the price is reduced to average cost, and every firm in the industry is earning regular profits.
In a different scenario, if the price gets below the average cost, the firms will be running on losses. In such a situation, a number of existing firms starts to leave the industry. Gradually, the output of the industry starts to decline, and the price starts to rise to equal the average cost so that the firms that are still in the industry can make regular profits.
Thus, in the long run, firms may not be forced to produce at a loss if others leave the industry for having a loss. For a perfectly competitive organisation to be in equilibrium in the long run, it must equal marginal and average cost. Now, when the average cost curve is declining, the marginal cost curve goes below it; and when the average cost curve is rising, the marginal cost curve goes above it.
Thus, marginal cost becomes the same as the average cost only at the point where the average cost curve is neither rising nor falling. This is the minimum point of the average cost curve. At the point of minimum average cost curve, these two elements are equal.
So, the conditions for the long run equilibrium of a perfectly competitive organisation can be expressed as:
Price = Marginal Cost = Minimum Average Cost.
If you look at this diagram above, you will get a better understanding of the conditions for the long run equilibrium of the company or firm under perfect competition. In the diagram, LAC is the long run average cost curve and LMC is the marginal cost curve. A perfect competition firm cannot be in the long-run equilibrium at price OP'. The reason is that the price OP' is the same as MC (marginal cost) at G (i.e., at output OQ). However, it is greater than the average cost at this particular output. Therefore, the firm will earn remarkable profits.
Since every firm is assumed to be identical, all of them would be earning remarkable profits. Hence, the industry will automatically attract new firms. The price will gradually decline to level OP, set itself at a price where the firm is in equilibrium at F and produces OQ” supply or output.
At point F or equilibrium output OQ", the average cost equals the price. So, the firm will be earning only regular profits. Now, at the price OP, new firms won't be interested in entering the industry. This will allow the firm to be in equilibrium at OP price and OQ output.
On the other hand, for a firm under perfect competition, it is not possible to be in the long-run equilibrium at price OP". Even though OP" price is same as a marginal cost at point E, or at output OQ" where price OP" is lower than the average cost at the point, the firm will still run at a loss.
In respect of cost curves, all the firms in the industry are identical. Basically, all of them would incur losses in a situation like that. To avoid these kinds of losses, some of the firms will definitely leave the industry. Due to that, the price will rise to OP, where all the firms are again making regular profits. As the price reaches the point OP, the firms will no longer be willing to quit.
Input and Output Determination under Imperfect Competition
Imperfect competition can be described in two different forms: i) Monopoly and ii) Monopolistic Competition.
When there is only one company or firm in a particular industry, then it is called a monopoly market structure. If a single firm is responsible for controlling 25 per cent or more of a given market, then the organisation is viewed as monopoly power.
A regular monopoly market structure generally comprises of various natural advantages including abundant mineral resources and strategic location. This explains why the Gulf countries have a monopoly in crude oil exploration. A monopoly market structure has these following key features:
In a monopoly market structure, firms generally produce goods without any close competition. In their cases, the product is generally specific and unique. If you remember the time when Apple Inc. released the iPad, it had a monopoly over the tablet market.
Challenges for new entries:
Getting into a monopoly market structure can be a lot difficult than usual for new firms. The entry of a new firm in a market set up by a monopolist firm will reduce the control of the monopolist on the industry.
There is generally no competition in a monopoly market structure.
In a monopolistic setup, the monopolist firm sets the price of the product. Since they have market power, they use it to become the price maker.
It is possible for a monopolist firm to maintain remarkable profits in the long run. However, it is not necessary for them to earn profits too. They can incur loss or maximise revenue as per their choice. This is not possible in perfect competition.
Monopolistic competition is a market structure that has the features of both monopoly and competitive markets. Generally, a monopolistic competitive market can allow entry and exit of new firms. However, sellers can differentiate their products. This allows them to set prices as they enjoy an inelastic demand curve.
Since other firms enjoy free entry in the market, the remarkable amount of profit can actually attract a lot of firms, which again reduces the profit to normal rates in the long run. Interestingly, the diagram for the monopolistic competition is similar to that of a monopoly in the short run.
Remarkable profits have always encouraged new firms to enter in the long run, which ultimately reduces the demand for existing firms. The key features of monopolistic competitive competition are the following:
- The number of firms in the market structure is plenty.
- The firms enjoy the liberty to enter and leave the market on their will.
- Firms produce various kinds of goods.
- Firms enjoy an inelastic price demand. Due to this, each firm is a separate price maker as the goods are highly differentiated.
- The firms earn a normal profit in the long run. However, there are remarkable profits in the short run.
- Since the firms have excess profit to invest in research and development, dynamic efficiency is likely.
- In a monopolistic competitive industry, the firms can experience competitive pressures to cut cost and deliver better products
As you may have learned by now, the price and output determination in different market structure can be different depending on the industry. And hopefully, you can now solve any problem regarding this topic on your own. However, if you aren’t able to do that, you can always ask for help.
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