Question

Suppose that, in a perfect competitive market, an equilibrium point is generated by intersecting downward
sloping market demand curve and upward sloping market supply curve. Explain step by step how to get
this equilibrium point from the decision making of INDIVIDAL consumers and producers. In your answer,
individual consumer’s decision making must start from preference ordering and utility maximizing process.
Producer’s decision making must start from budget constraint, production function and go to the process of
cost minimization and profit maximization. Also explain how to move from individual decision makings
to the entire market interaction. In your answer, include all necessary steps, concepts, graphs, formulas, etc.
which you have learned during this course. Make a coherent, analytic essay.
(Note: in perfect competitive market, a supply curve of individual firm is different to the market supply
curve.)

Answer 1

Perfect competition is considered as the base structure of a market upon which the other market structures hover around. A perfectly competitive market is also considered a myth owing to the characteristics of such a market. A Perfectly competitive market has a huge number of firms which produce identical or homogeneous product. One critical feature of this type of market is that all the firms are relatively small, or in other words none of the firms is so big that it can influence the factors of market determination. Let us see how a perfectly competitive market sustains from the point of view of the complete market and that of an individual consumer or producer.

                                   As can be seen from the diagram above, the Demand curve depicts the demand prevailing in the market in correspondence to the supply prevailing in the market. The Equilibrium price of the market is determined at point E where the demand and supply curves intersect. This point determines the price prevailing in the market. This price has to be born by the individual consumers and producers in the market (as can be seen from the Second figure, the Individual graph) . The characteristic of a perfectly competitive market is that the price in the market is fixed a point where the demand and supply meet at the equilibrium and all the firms in the market have to follow the same price to sustain in the market. The consumer also needs to purchase the product or good at that same price. The entry and exit of firms are free in a perfectly competitive market, i.e. there are no barriers or restrictions in the entry or exit of any firm at any time.

                              As can be seen form the second diagram, the price curve is being intersected by the marginal cost and the average cost curves. The marginal cost and the average cost curve are u shaped in this type of market structure. The demand, supply and the price of a product in this market is the same. An individual has to sustain in a perfect competition by following the market flow. i.e. an individual has no influence upon the production, supply or on the price of a product in this market. An individual producer has to decide if he can produce products at the prevailing price in the market. If he produces products such that his cost of production is higher or equivalent to the price prevailing, then he cannot survive. However, if he can manage to produce the same product at lesser cos, then hi chances are bright in this type of a market structure. Similarly, for an individual, he needs to carry out his financial decisions such that he can survive at the price prevailing in the market. An individual consumer has no say upon the market conditions, since the number of consumers in a perfectly competitive market, is huge.