Did you buy something recently? Maybe it was a new jacket? A top? A new game console? Whatever it was, how much did you pay for it? The price can range from 50 pence to 500 pounds. What determines the price of a good or service? This article will show you how price determination in a competitive market is done.
What is a competitive market?
A perfectly competitive market, or a competitive market, is one in which no single producer is the dominant supplier. A competitive market is a market with many buyers and sellers.
Learn more about this type of market in our article Perfect Competition.
Meaning of price determination
Price determination relates to how the forces of supply and demand interact in a market.
Price determination is the process of how the forces of demand for goods and services and the supply of goods and services in a market interact to determine the price.
The level of consumer demand for a product and the response, the supply of producers, play a critical role in determining the price of that product.
A company produces and sells face masks for £1 because of the pandemic and the government’s safety guidelines. Since face masks are mandated, the demand for face masks has increased. Knowing that consumers need face masks, the company increases its supply of face masks to meet the increased demand and increases the price from £1 to £2.This example is just one example of how changes in demand and supply can affect the price of a good or service. This interaction is called price determination.
Price determination under perfect competition
Now that we know what a competitive market is and what price determination is in general, let us look at how prices are determined in this type of market.
the interaction of market demand and market supply determines the price in a competitive market. From Figure 1 below, we can see a point where demand (D) and supply (S) meet. At this point, D = S, which is called the market equilibrium. The corresponding price at the point of market equilibrium, Pe, is called the equilibrium price. The equilibrium price is the price at which the numerous suppliers are willing to supply the market and the numerous consumers are willing to buy.
Fig. 1 - Price determination in a competitive market
In reality, however, it is not always easy to know where S = D and thus to determine the equilibrium price. For this reason, we often face some challenges, such as disequilibrium, excess supply and excess demand.
Disequilibrium is an economic situation characterised by a shortage or excess of demand or supply. Disequilibrium occurs when the intended demand of consumers does not match the intended supply of businesses.
Excess demand is an economic situation in which consumers are willing to buy more than firms are willing to supply in the market.
Excess supply is when firms are willing to offer more in the market than consumers are willing to buy.
These challenges make it much more difficult to set prices. However, in our article Market Equilibrium you will see how the market can change when problems such as imbalance, oversupply and scarcity occur.
How does the interaction of demand and supply determine equilibrium price in a market economy?
The interaction of supply and demand determines the equilibrium price in a market economy because they are opposing factors in the market. Consumers are willing to purchase a product at a price that depends on their income and other factors, while firms are willing to offer products at a certain price considering their total costs. These two forces enter the market with their individual prices and agree to trade so that no player is disadvantaged.
Importance of price in the market
Price is a critical factor in the demand and supply of goods and services in a market. Price plays an important role in the market in the following ways:
- The flagging function serves as an indicator of when there is a surplus or shortage in the market. The price has the function of signalling a shortage or a surplus in a market and giving the main actors the opportunity to react.
- The decision-making function serves as a tool to help the main actors in the market to know how to react. Price helps consumers to make a decision about buying a product and attach value to the product. It also plays a decision-making role for suppliers, as it reveals consumers’ needs and wants, which the supplier uses to make an informed decision.
Role of demand and supply in price determination
Demand and supply play different roles in the process of price determination. Before we look at their roles, we should define both terms.
Demand refers to the desire of consumers to purchase goods and services at certain prices.
Supply refers to the quantity of a good or service that firms are willing to produce and put on the market.
The law of supply and demand clarifies the relationship between supply and demand and how they affect the prices of goods and services, explaining the interrelationship between supply and demand markets.
Learn more about the law of demand in our article ‘Demand’ and the law of supply in our article ‘Supply’.
We can also see how demand and supply can determine a good or service price through elasticity.
Elasticity is an economic measure of how sensitive one economic factor is to another. For example, how does demand change when people’s income changes?
There are four types of elasticities.
Price elasticity of demand
Price elasticity of demand (PED) measures the change in the quantity demanded of a product relative to a change in its price. In our article’ Price Elasticity of Demand’, you will be able to calculate PED and understand how price changes can affect consumer demand.
Price elasticity of supply
Price elasticity of supply (PES) measures the percentage change in the supply of a good or service when the price changes. Our explanation of ‘Price Elasticity of Supply’ will help you understand how companies change their supply of a good or service when the price changes. You will also see what factors determine how quickly companies respond to price changes.
Income elasticity of demand
Income elasticity of demand (YED) measures the percentage change in a consumer’s income relative to the number of goods consumers demand. You might expect a change in a consumer’s income to affect the number of goods or services they demand. Still, in our article ‘Income Elasticity of Demand’, you will see that this relationship is affected for different types of goods.
Cross price elasticity of demand
Cross elasticity of demand (XED) measures the percentage change in the quantity demanded of one good (e.g., good A) versus the percentage change in the price of another good (e.g., good B). In our explanation of ‘Cross Elasticity of Demand’, you can calculate XED and understand precisely the relationship between two goods.
Price Determination in a Competitive Market - Key takeaways
- Price determination is how the forces of demand for goods and services and the supply of goods and services in the market interact to determine the price of those goods and services.
- A perfectly competitive market, or a competitive market, is one in which no single producer is the dominant supplier, a market that offers consumers a wide choice of suppliers.
- The interaction of market demand and market supply determines the price in a competitive market.
- The point at which demand (D) and supply (S) meet is called the market equilibrium.
- The corresponding price in the market equilibrium is called the equilibrium price.
- Shortages and excess supply in a market lead to market disequilibrium.
- Using elasticities, we can see how supply and demand can determine the price of a good or service.
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