Question

Explain how price is determined in a perfectly competitive market with fixed number of firms.

Answer 1

When the number of firms in a perfectly competitive market is fixed, the firms are operating in the short-run. The equilibrium price is determined by the intersection of market demand curve and supply curve. It is the price at which the market demand equals market supply.

In the given figure, if at any price above P^e, let us say Rs 12, there will be an excess supply, which will increase the competition among the sellers and they will reduce the price in order to sell more output. This causes a fall in the price, finally to Rs 8 (P^e), where the demand equals supply.

If at any price lower than P^e , let us say Rs 2, there will be an excess demand that will raise the competition among the buyers or consumers and they will be ready to pay higher price for the given output. This will increase the price to Rs 8 (equilibrium price), where the market will reach the equilibrium.

Thus, the invisible hands of market operate automatically whenever there exist excess demand and excess supply; ensuring equilibrium in the market.