Competitive Markets - Perfect Competition and Market Equilibrium

Concept of Competitive Markets:
 
Chapter Summary:

This unit discusses the conditions for perfect competition. It as well investigates the importance of competitive equilibrium in a perfectly competitive market. It describes the meaning of surplus demand and supply.

To understand the total effect of a shift in demand or supply, it is essential to consider both sides of the market. Usually, the effect of any modification in the demand or supply based on elasticity with respect to the price of both demand and supply.

The time horizon is a key factor influencing the elasticity of demand and supply. Prices are much volatile and quantity adjustment takes comparatively longer in industries where production includes substantial sunk costs.

Finally, it is significant to differentiate a receipt or payment from incidence. The payment or receipt can be shifted from one side to other of the market. Incidence is basic and based only on the elasticity of demand and supply.
 
Key Concepts:

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General Chapter Objectives:

A) Mention why the demand-supply frame-work is the core of managerial economics.

B) Explain the characteristics of perfect competition.

C) Find out the market equilibrium, elucidate why it exists and how it might change.

D) Forecast the impact of a change in demand-supply on market price and quantity in the short run and elucidate the dynamics included in moving from an initial equilibrium to new market equilibrium.

E) Compute a short-run change in equilibrium price and quantity employing elasticity.

F) Forecast the impact of a change in demand and supply on market price and quantity in the long run and elucidate the dynamics included in moving from an initial equilibrium to new market equilibrium.

G) Compute a long-run change in equilibrium price and quantity employing elasticity.

H) Differentiate freight inclusive pricing and ex-works pricing.

I) Talk about the incidence on sellers and buyers given a shift in demand or supply.
 
Notes:

1) Introduction: It is significant to consider both demand and supply whenever predicting the impact of any change on price and quantity. Even although only one side of the market might be changing initially, it is essential to consider the interaction with the other side to acquire a complete picture.

2) Demand-supply framework (or perfect competition).

a) The demand-supply framework (or perfect competition) is the core of managerial economics. This can be applied to address business issues in a broad range of markets, comprising services and goods, consumer and also industrial products, and items sold in international and domestic markets.

b) Market demand and supply:

i) Whenever deriving a market demand curve, it is supposed that each and every buyer can purchase as much as she would like at going price and all buyers pay similar price.

ii) Whenever deriving a market supply curve, it is supposed that every seller can deliver as much as she would like at the going price and all sellers obtain similar price.

c) 5 assumptions or conditions for perfect competition. When a market meets the five conditions for perfect competition, we can genuinely apply the concepts of demand and supply.

i) The product is homogeneous (that is, they are perfect substitutes).

  • The competition in a market where products are distinguished (example: mineral water, owing to chemical and marketing differences) is not as keen as that in the market where products are homogeneous. 
  • Usually, prices for differentiated products are distinct.

ii) There are lots of buyers, each of whom purchases a quantity which is small relative to the market.

  • In a market where several buyers contain market power, different buyers pay distinct prices: The buyers with market power acquire lower prices.
  • Where some buyers encompass market power, it is impossible to make the market demand curve as the buyers with market power can influence the going price.

iii) There are lots of sellers, each of whom supplies a quantity which is small relative to the market.

Where some sellers encompass market power, it is impossible to construct market supply curve as the sellers with market power can influence the going price.

iv) New buyers and sellers can enter without restraint, and existing buyers and sellers can leave freely. There are no regulatory, technological or legal barriers.

  • With free exit and entry, the market price can’t stay above a seller's average cost for very long.
  • If the market price is above seller’s average cost, the new sellers will enter, add to the market supply, and bring downward the price. 

v) All buyers and sellers contain equal information regarding market conditions (example: substitutes, prices and technology).

Markets where there are dissimilarities in information among sellers, among buyers or between sellers and buyers, are not as competitive as such where all buyers and sellers contain equal information.

3) Market equilibrium:

a) Definition of market equilibrium: It is the price at which, the quantity demanded equivalents the quantity supplied (that is, a price in which there is neither a surplus nor a scarcity).

i) The price will not tend to modify: the quantity demanded just balances the quantity supplied.

ii) Purchases will not tend to modify: buyers maximize profits less expenses.

iii) Sales will not tend to modify: sellers maximize gains.

b) Excess supply: the amount by which the quantity supplied surpasses the quantity demanded.

i) If the market price is above equilibrium, buyers will cut back the purchases.

ii) The sellers will compete to clear their additional capacity, and market price will fall back in the direction of equilibrium level.

c) Excess demand (or a shortage): It is the amount by which the quantity demanded surpasses the quantity supplied.

i) The lower is the market price beneath equilibrium; the greater will be the surplus demand.
ii) Buyers will compete for the restricted capacity: the market price will tend to increase to the equilibrium level.

d) When a market is not in equilibrium, sellers or buyers will push the market in the direction of equilibrium. By applying the concept of market equilibrium, we can forecast the impact on price and quantity given changes in supply or demand (where there is a modification in economic variable, example; the price of related product, the cost of inputs, or government policy).

e) Very few markets precisely satisfy all five conditions for the perfect competition. We can still apply the demand-supply analysis however must check the implications against the unsatisfied conditions.
 
4) Supply shift:

a) Changes that shift the supply curve:

i) Example: Modification in the cost of inputs, or government policy.
ii) Raise in supply at each and every price: a downward (or rightward) shift in the supply curve of the output.
iii) Reduction in supply at every price: upward (or leftward) shift in the supply curve of the output.

b) Modification in the equilibrium price: To understand the impact of a supply shift, we require considering the interaction among demand and supply. Given a change in the cost of an input, and a change in demand-supply, the change in the equilibrium price based on the price elasticity of both demand and supply.

i) Extremely elastic demand and extremely inelastic supply.

  • If demand is extremely elastic, buyers are very sensitive to price. Whenever the supply curves shifts, buyers soak up all the extra quantity supplied (or give-up all reduction in quantity supplied), and the equilibrium price remains unaffected.
  • Whenever supply is very inelastic, sellers are totally insensitive to price (that is, they give the similar quantity regardless of the price of the output or costs of inputs). Whenever the cost of inputs modifies, sellers give the similar quantity, and the equilibrium price remains unaffected.

ii) If demand is more elastic than the supply, then the change in equilibrium price resultant from a shift in supply will be smaller.

iii) When demand is less elastic than supply, then the modification in equilibrium price resultant from a shift in supply will be bigger.

iv) Extremely inelastic demand or extremely elastic supply.

  • Whenever demand is extremely inelastic, buyers are totally insensitive to price (that is, they purchase similar quantity regardless of the price). Whenever the supply curve shifts, buyers purchase similar quantity and the equilibrium price changes by similar amount as the supply shift.
  • Whenever supply is extremely elastic (that is, the marginal cost of production is steady). If an input cost modifies, the marginal cost changes by similar amount at all production levels.  Whenever the supply curve shifts, the equilibrium price changes by similar amount as the supply shift.

v) An upward or downward shift in the supply curve will modify the equilibrium price (to the latest equilibrium price) by no more than the amount of supply shift.

Note: There is a general misconception is that, when seller's costs drop by some amount, then the market price will drop by similar amount. In real world:

  • Market demand is somewhat however not very sensitive to price. Whenever the supply shifts down, the price would fall by less than the downward shift. Whenever the supply shifts up, the price would increase by less than the upward shift.
  • Supply is somewhat sensitive and elastic to price. A seller can usually raise supply with more capacity and higher costs. Whenever the supply shifts down, the price would drop. Whenever the supply shifts up, the price would increase.

5) Demand shift:

a) Modifications that shift the demand curve.

i) Example: Changes in prices of substitutes or compliments, or government policy.
ii) Raise in demand at each and every price: an upward (or rightward) shift in the demand curve of output.
iii) Reduction in demand at every price: downward (or leftward) shift in the demand curve of the output.

b) Modification in the equilibrium price. To understand the impact of demand shift, we require considering the interaction between demand and supply. The change in the equilibrium price based on the (output) price elasticity of both demand and supply.

Note: The general misconception is that, when demand raises by certain amount, then the market quantity will rise by similar amount. This overlooks:

  • The impact of demand shift on sellers: the marginal cost of generating an additional unit of output may change.
  • The price sensitivity of buyers: the amount buyers are eager to pay for an extra unit of output.

6) Computing equilibrium changes:

a) To obtain a specific estimate of the consequence of a supply or demand shift on the market price and quantity, we require knowing either the whole demand and supply curves or the relevant elasticity. Information on elasticity is frequently more readily accessible than the whole demand and supply curves.

b) Formula to compute changes in the market equilibrium:

i) Compute the percentage change in quantity demanded; 
ii) Compute the percentage change in the quantity supplied;
iii) Equate such percentage changes to resolve for the percentage change in price; and
iv) Compute the percentage change in quantity.
 
7) Adjustment time:

a) Since the elasticity of demand and supply differ with the time horizon beneath consideration, shifts in demand and supply might have distinct short-run and long-run effects.

b) Whenever a market is in both long-run and short-run equilibrium:

i) For each individual buyer: the quantity bought where marginal benefit equivalents price.

ii) For each individual seller: the quantity given where marginal cost equivalents price.

iii) At equilibrium price, the market demand curve (or horizontal summation of individual demand curves) crosses the market supply curve (that is, horizontal summation of individual supply curves).

iv) The equilibrium price signals to each and every buyer and seller the amount to purchase and provide, correspondingly.

c) Short-run market equilibrium:

i) Definition: the price at which the short-run quantity demanded equivalents the short-run quantity supplied.
ii) For each individual seller: the short-run marginal cost equivalents market price.

d) Long-run market equilibrium:

i) Definition: It is the price at which the long-run quantity demanded equivalents the long-run quantity supplied.
ii) For each individual seller: The long-run marginal cost equivalents market price.

e) Demand increase:

i) Assumptions:

  • Beginning from short and long-run equilibrium.
  • Short and long-run demand curves are similar.

ii) Upon a demand increase:

  • New short-run equilibrium.
  • New long-run equilibrium.

iii) Whenever supply is more elastic in long-run than in the short-run and demand rises:

  • The price in long-run equilibrium is lower than in the latest short-run equilibrium however greater than in the original equilibrium. 
  • The quantity in new long-run equilibrium is greater than in the new short-run equilibrium that in turn is higher than in the initial equilibrium.

iv) Sunk costs: In an industry including substantial sunk costs, price will be comparatively volatile. The short run price will surpass the long run price. As well, adjustment of production will be concentrated in long run.

v) Short in respect of long run.

a) The market price will be much volatile in short run than the long run; that is, the market price will modify more in the short run than in long run.

b) There is a big change in the market quantity over the long run than in short run; that is, the quantity will modify more in the long run than in short run.

8) Receipts in relation to incidence:

a) Usually, the price and sales are similar.

i) "Cost and freight (CF) price": a price which comprises the cost of delivery to the buyer.
ii) "Ex-works price": a price which does not comprise the cost of delivery to the buyer.

b) “Incidence": the modification in the price for a buyer or seller resultant from a shift in demand or supply. The incidence of freight charges, brokerage fees and govt. taxes depends not on whether the sellers do or do not comprise the freight cost in their prices, only on the price elasticity of demand and supply.

Question Answer:

Assume that Bell's Soup is planning to cut the wholesale price of its tomato juice by $1 per carton. Consider the retail market, where supermarkets and grocery stores sell tomato juice and consumers purchase the product. Beneath what circumstances would the wholesale price cut have the least consequence on the retail price? Please illustrate conditions in terms of the price elasticity of retail demand and supply. Demonstrate your answer with appropriate graphs.

Answer:

The figures shown below depict the retail market for tomato juice. We symbolize the $1 wholesale price cut by shifting down the retail supply by $1. Let the original equilibrium be at point e.  From the analysis shown below, the impact of the wholesale price cut on the retail price will be least when the retail supply is very inelastic and the retail demand is much elastic.  
a) Price elasticity of supply: Referring to the figure shown below, if supply is much inelastic, then the impact of wholesale price cut on the retail price will be much smaller than when the supply is elastic.

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b) Price elasticity of demand: Referring to the figure shown below, when demand is much elastic, then the impact of the wholesale price cut on retail price will be much smaller than when the demand is inelastic.

1347_competitive markets2.jpg

 

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