Determination of price and quantity supplied in perfectly competitive market in the short run treating demand as exogenous
Consider the situation of a perfectly competitive market (here competitive refers to competition between suppliers), facing a specific market demand curve. This page briefly overviews how the price and quantity supplied in the competitive market are determined, and why there are theoretical reasons to believe these choices to be welfare-maximizing.
Note that perfect competition is not strictly necessary for the general qualitative contours of the analysis, though a reasonable level of competition is.
The following are some relevant features of competitive markets:
- Each firm is small in size relative to the totality of all firms supplying the good, and is competing solely on price (i.e., with no product differentiation).
- The firm is a price taker rather than a price setter, i.e., it has no leeway in deciding the price and must stick to the price prevailing in the market (there are exceptions to this when the price is not at the market equilibrium; see the convergence towards market price page).
- Whatever quantity the firm produces within its natural limitations can be completely sold at the market, i.e., the firm does not have to worry about unsold inventory as long as it prices products at the market price.
Setting the price at the market price is not (necessarily) enforced through any legal regulation, but is forced for the following two reasons:
- Because the firm is very small relative to the whole market, reducing the price below the market price will shift much more consumer demand to that firm than the firm can handle.
- Similarly, increasing the price above the market price will cause the firm to lose all its customers to competing firms.
Treatment of the market demand curve as exogenous
This page does not deal with the story behind the market demand curve, which is treated as exogenously determined.
This page does combine a discussion of the determination of the market supply curve and the determination of the equilibrium point once both the supply and demand curves are known. The two levels can be neatly separated. However, this neat separation is a feature specific to competitive markets and does not apply to other market structures such as monopolistic or oligopolistic structures. Thus, for an easy point of comparison with these alternative structures, we provide the combined analysis here.
The optimization process is two-level
In a perfectly competitive market, there are two levels of optimization.
|Level||What gets determined here||What data is used?||Details||More information|
|Single firm, deliberately attempting to optimize for profit||Optimal quantity to produce as a function of price, encoded in the firm's individual short run supply curve. These can be aggregated to obtain the market supply curve.||The firm's marginal cost curve only. The market demand curve is not used.||The firm uses its marginal cost curve to determine the optimal quantity to produce as a function of market price. In other words, for any given market price, the firm can use its marginal cost curve to determine the optimal quantity to produce. This choice is encoded in the firm's short run supply curve, which in turn is determined by the firm's marginal cost curve. Although it is not immediately obvious, the firm's short run supply curve coincides geometrically with (part of) the firm's marginal cost curve.||Determination of quantity supplied by firm in perfectly competitive market in the short run|
|Market as a whole, including all firms making micro-adjustments but not necessarily with full information||The market price and quantity traded||The market demand curve (though an individual seller may see only a part thereof)||Firms experiment with raising or lowering prices, and correspondingly raising or lowering the quantity produced (while staying on their individual short run supply curve obtained above) until the market clears. Note that the short run market supply curve used in the analysis of convergence is obtained by adding up all the short run supply curves for individual supply curves obtained at the preceding level.||Convergence towards market price.|
In other words, the functional relationship between price and quantity traded (i.e., the supply curve) is determined through firm's individual optimization decisions, through "local knowledge", independent of other firms and independent of the market demand. The actual value of price and quantity traded are determined through the interaction of buyers and sellers in the market as they gradually adjust values to make the market clear.