Here is an elaborated discussion on market price determination under perfect competition.
They are two points to note about a perfectly competitive market:
(1) In any perfectly competitive market both buyers and sellers are price takers and quantity setters; that is, each regards price as given and responds to it by selecting the quantity he wishes to buy or sell at that price.
(2) The quantity response to price to buyers as a group can be represented by a downward-sloping market demand curve, while the quantity response to price of sellers as a group can be represented by an upward-sloping market supply curve.
Now- How can we characterize the equilibrium price in a perfectly competitive market?
From the standard definition of equilibrium, it follows that-
An equilibrium price in a perfectly competitive market is one that, when established will persist so long as the various factors that determine the positions of the market supply and demand curves do not change. The only price that would fit this definition is one that elicits manually consistent quantity response from both buyers and sellers.
If the price established in a perfectly competitive market did not elicit mutually consistent quantity responses from buyers and sellers (i.e., if it did not equate supply and demand), there would be either a group of unsatisfied sellers who could not sell as much as they would like to at that price or a group of unsatisfied buyers who could not purchase as much as they would like to at that price.
The attempts of this group of unsatisfied individuals to increase either their purchases or their sales would inevitably alter market price. What is the equilibrium position of the market in Fig 21.1? Obviously at any price above P0, the quantity offered by producers will exceed the quantity demanded by consumers. Suppose that price were set at P’.
Then supply would exceed demand, and there would be excess supply equal to Es, which indicates that, if the price P’ prevailed, some suppliers would not be able to sell as much as they would like to. This group of unsatisfied sellers could be eliminated only by a fall in market price that would simultaneously increase demand and decrease supply.
At any price below P0, the quantity demanded by buyers will exceed the supply offered by producers. Thus, for example, if price were sec at P”, there would be demand equal to Ed, which would mean that there was a group of unsatisfied buyers who could be eliminated only by a rise in market price that would decrease demand and increase supply.
At the price P0, however, demand equals supply (i.e., the quantity responses of buyers and sellers to price are mutually consistent), and no unsatisfied group of buyers or sellers exists. Hence P0 must represent the equilibrium price.
We thus conclude that:
In a perfectly competitive market, the equilibrium point is at the intersection of the market demand and supply curves, because this is the only point at which supply and demand are equal. Since both buyers and sellers in perfectly competitive market set quantity in response to price, in such a market price plays the key role of an equilibrating variable.
It is through upward and downward adjustments in price that the market attains equilibrium. Whenever the market supply curve or the demand curve shifts, price will change and there will be a new equilibrium.
Here we have simultaneously been characterizing the equilibrium quantity sold. If the market in 21.2 attains equilibrium at the price then, obviously, the quantity of output sold in equilibrium must equal since represents the quantity response that both buyers and sellers would make to the price P0.
Once we know the equilibrium price, we can determine not only the quantity of output that will be traded, but L the amounts that all individuals in the market will buy and sell at that price.
Effect on Equilibrium of Shifts in Market Demand and Supply:
We have defined the equilibrium values of price and quantity sold in a perfectly competitive market as values that will be maintained so long as the factors which determine the position and shape of the market demand and supply curves remain the same.
Over time, however, the other things-constant (ceteris paribus) assumption that underlies both the supply and the demand curve cannot be maintained. Whenever it is violated one or both of these curves will shift. What effect will such a shift have on market equilibrium?
Shift in Market Demand:
Fig. 21.2 shows the impact on equilibrium of such an upward and rightward shift. The initial market demand curve is the curve D; the market is initially at price P0 and output Q0. As consumers’ demand for apples increases, the demand curve shifts upward from D to D’ which creates excess demand at the old equilibrium price, P0.
The excess demand, Ed, forces prices upward until a new equilibrium is established at price P’ and output Q’, which correspond to the point of intersection between the new market demand curve D’ and the market supply curve S.
Shift in Market Supply:
Fig. 21.3 shows the effect of this downward and rightward shift in the market supply curve (note that this corresponds to an increase in the supply of apples). The initial market supply curve is the curve S: the market is initially in equilibrium at price P0 and output Q0. As the cost of producing apples decreases, however, the market supply curve for apples shifts rightward from S to S’.
This shift, which creates excess supply equal to Es at the old equilibrium price P0, causes price to fall until a new equilibrium is established at the point (P’, Q’) at which the market supply curve S’ intersects the market demand curve D.
This example shows that a rightward shift in the market supply curve (i.e., an increase in the supply) lowers the equilibrium price and increases the equilibrium quantity sold A leftward shift in the market supply curve (i.e., a decrease in supply) would have the opposite effect.