# Chap-5 - PRICE DETERMINATION UNDER PERFECT COMPETITION 85 U...

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F ORMS OF M ARKET AND P RICE D ETERMINATION UNIT-IV

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The foundations underlying the demand and supply curves were laid in Chapters 2 and 4 respectively. These curves respectively tell us how much consumers demand and how much producers supply at different prices. But they do not tell us what the actual price of the product will be (in principle) or, in other words, what points on the demand or the supply curve will be actually chosen in the market place. This issue is addressed in this chapter by pooling together what we have learnt about the demand and supply. It forms the core of how the market system works in particular how an economy’s central problem of “what” is solved through the price mechanism. You will see that there are not many new concepts or definitions to be learnt. The emphasis is on applications. A number of examples will be provided as we proceed. 5.1 MARKET EQUILIBRIUM AND DETERMINATION OF PRICE AND QUANTITY Consider fig. 5.1. It depicts the market demand and supply curves of a particular product, denoted respectively by DD and SS . The question is: which price will prevail in the market? Suppose that, initially, the price P RICE D ETERMINATION U NDER P ERFECT C OMPETITION C HAPTER 5 5.1 Market Equilibrium and Determination of Price 5.2 Demand and Supply 5.3 Sources of Demand 5.6 Efficiency of the Price Mechanism and 5.7 Economic Policy by the Government and Market
P RICE D ETERMINATION U NDER P ERFECT C OMPETITION 87 in the market for that good is P 1 . At this price, the consumers demand the quantity D 1 and the producers supply the quantity Q 1 . Obviously, there is a mismatch. Consumers want more than what the producers are willing to supply. There is excess demand , equal to AB or Q 1 D 1 . 1 Will then the price stay at P 1 ? No, excess demand will create competition among the buyers and push the price up. It will increase, say, to P 2 . Excess demand is present at this price also. Thus price will increase further. Indeed, the price will keep increasing as long as there is an excess demand. This is indicated by the upward-looking arrow. Finally it will converge to P O , at which there is no excess demand. Just the opposite happens if initially the price is P 3 . The quantity demanded ( D 3 ) is less than the quantity supplied ( Q 3 ). There is excess supply , equal to D 3 Q 3 which will create competition among the sellers and lower the price. The price will keep falling as long as there is an excess supply. It is indicated by the arrow, pointing downwards. Where will the price finally settle? The answer is again P 0 , at which there is no excess supply. The situation of zero excess demand and zero excess supply defines market equilibrium . Alternatively, it is defined by the equality between quantity demanded and quantity supplied. In fig. 5.1, it is shown at the point E 0 . The price P 0 is called the equilibrium price . Recall that equilibrium means a position of rest.

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## This note was uploaded on 04/20/2010 for the course CEDT 601 taught by Professor Ypr during the Spring '00 term at Indian Institute of Technology, Kharagpur.

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Chap-5 - PRICE DETERMINATION UNDER PERFECT COMPETITION 85 U...

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