Perfect Competition and Theory of Supply and Demand - Essay Example

The theory of supply and demand is essential in understanding the functioning of a market economy and explaining changes in the price and quantity of goods in both competitive and monopolistic markets.

Theory of Supply and Demand
 In microeconomic theory, the supply and demand model attempts to describe, explain and predict the price and quantity of goods sold in competitive markets. This model assumes that markets are perfectly competitive i.e. there are many buyers or sellers, none of whom have the capacity to influence the price of goods or services on offer. A simple supply and demand model is shown below. The slope of the demand curve indicates that a greater quantity will be demanded when the price is lower. Similarly, the supply curve shows that as prices rise, firms will produce more goods or offer more or better services. The point where these curves meet is the equilibrium point.

Perfect Competition
 A market is said to be in perfect competition when no producer or consumer has the market power to influence prices. In such a market, prices of goods would instantly shift to the point of equilibrium as illustrated in the supply and demand graph. In competitive market economies, actual prices tend to be the equilibrium prices at which demand equals supply. At the point of equilibrium, there is no incentive to change either the price or the quantity. (Stiplitz J & Drifill J, 1993, p 73).

Perfect competition depends on a set of conditions being fulfilled. These as per the Wikipedia Encyclopedia are:

Atomicity – there are a large number of producers and consumers, each so small that their actions have no impact on others. Producers are ‘price takers’, meaning that the markets set the price.

 Homogeneity – goods, and services have perfect substitutes, i.e. that there is no product differentiation.

Perfect and Complete Information – all firms and consumers know the prices set by all others.

Equal Access - all firms have access to production technologies, and resources are perfectly mobile.

 Free Entry – any firm may enter or exit the market as it wishes.

Since the price is fixed as the result of the interaction of supply and demand, nothing producers can do will affect the price and every unit that sells results in marginal revenue. They are in perfect competition, price = marginal revenue = average returns (Whitehead, p 105). Demand has a very direct and immediate effect on prices since the supply factor will always have some lead time, i.e. till adequate stocks are built up or surplus stocks are disposed of. This temporary shortage or excess has a bearing on prices. A temporary shortage has the effect of boosting prices, and under the influence of these profits there is an increase in production until supplies once again catch up with demand and until a new equilibrium point is reached, as shown in the figure below. Conversely, a drop in demand lowers prices and eventually leads to decreased supply. Thus competition results in a higher output at a lower price.

 Monopoly
 A monopoly is defined as a persistent market situation where there is only one producer of a particular product or service. They are characterized by a lack of economic competition for the goods or services provided including the lack of viable substitutes. As per the Wikipedia Encyclopedia, the primary characteristics of a monopoly are as follows:

            Single seller – a single firm is the sole producer of a product or service.

             No close substitutes – the product or service is unique.

 Price maker – a single firm controls the total supply of the product and is able to exert a significant degree of control over the price by changing the quantity supplied.

 Blocked entry – certain barriers keep potential competitors away from the market.           

In most real markets, a drop in demand is associated with a price increase, as illustrated earlier, either due to losing customers to others or because the buyer is no longer willing (or able) to buy the product. In a monopoly, however, only the second factor is in effect. This is shown in the figure below. In a monopoly, the price will be set where the marginal cost (MC) equals marginal returns or revenue (MR). This will be at the quantity (Qm) and price (Pm). This is above the equilibrium point of a competitive market that would exist at a lower price (Pc) and larger quantity (Qc). In a monopoly, therefore, it is very advantageous to raise prices as the producer gets more money for lesser goods. Thus in a monopoly, the effect is a lower level of output at a higher price.

The theory of supply and demand can be used to predict movements in prices and quantity or output based on the model described. This theory forms the basics of modern microeconomics. In a perfectly competitive market, any lowering of prices results in an increase in the number of goods that are supplied till a new point of equilibrium is reached. In actual fact, however, imperfect competition is more typical with firms competing vigorously against each other, since the conditions necessary for perfect competition to exist are unlikely to occur.