Under perfect competition, the price of a good or service is not determined by individual firms but rather emerges through the interaction of supply and demand in the entire market. Here’s how it works:
1. Market Demand and Supply Curves:
- Market demand curve represents the total quantity of a good that buyers are willing and able to purchase at different price levels. It typically slopes downward, indicating that as the price increases, consumers are willing to buy less.
- Market supply curve represents the total quantity of a good that firms are willing and able to sell at different price levels. It typically slopes upward, indicating that as the price increases, firms are willing to sell more.
2. Equilibrium Point:
- The equilibrium price is the price at which the market demand and supply curves intersect. This point represents a state of balance where the quantity of a good that buyers are willing to buy (demand) is equal to the quantity of the good that firms are willing to sell (supply).
3. Price Takers:
- Since there are numerous buyers and sellers in perfect competition, individual firms cannot influence the market price. They are price takers, meaning they accept the market-determined equilibrium price and adjust their production levels accordingly.
4. Profit Maximization:
- In the short run, firms in perfect competition may earn positive economic profits if the market price is above their average cost of production.
- However, in the long run, free entry and exit ensure that firms are driven towards a state of zero economic profit. This occurs because if a firm is earning positive economic profits, other firms will be incentivized to enter the market, increasing supply and driving down the price. Conversely, if firms are experiencing losses, they will exit the market, reducing supply and allowing the price to rise.
5. Efficiency:
- Perfect competition is considered efficient because it leads to the allocation of resources in a way that maximizes total economic surplus, which is the sum of consumer surplus and producer surplus.
In summary, under perfect competition, the price is not set by individual firms but is determined by the equilibrium point where market demand and supply meet. Firms act as price takers and adjust their production levels to maximize profits within this market-determined framework.