4.5 Pricing in Competitive Markets

[4.2 Market Power] [4.3 Pricing with Market Power]

[4.4 Pricing Strategies] [4.6 Entry and Exit]

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 Q_d=Q_s=Q*, where Q_d is the quantity demanded and Q_s 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.

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, Q_d, is much greater than the quantity supplied, Q_s. The difference between Q_s and Q_d 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, Q_s, is much greater than the quantity demanded, Q_d. The difference between Q_d and Q_s is excess supply.

It should be noted that only at the equilibrium price does the quantity demanded equal the quantity supplied.

Click the link here to find out how to use maths to find equilibrium price and quantity mathematically.

To find out how to use algebra to solve the two equations for the two variables, P* and Q*, view the following animation.

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

· consumer income

· prices of related goods

· advertising and consumer preferences

· population

· expectations

The primary factors that may cause a change in supply, or a shift in the supply curve, are

· input prices and taxes

· technology and government regulation

· profitability of substitutes in production

· number of firms

· 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*.

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.

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.

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.

Comparative Statics - a Mathematical Approach

The interactive object here will allow you to explore the effects of simultaneous supply and demand shifts on equilibrium price and quantity. Notice that there are four possible combinations for supply and demand curve shifts. Also, notice that the effect on the equilibrium price and quantity is different depending on whether the change in supply or the change in demand is larger.

The following animation should clarify the changes in equilibrium price and quantity that result from changes in supply or demand.

Click the link here for the mathematical approach to how changes in supply and demand affect market equilibrium prices and quantities.

Click on the link here to find out how a change in the slope parameters affects the equilibrium price and quantity