Right now we are able to see how the prices are determined in a competitive market. We can show how buying decision of households and supplying decisions of producers affect the final price of a good.
Let’s study the table above, in which we can see the supplied and demanded quantity at different price units of a good. After a careful examination of it we can understand that at higher price suppliers are willing to sell more quantity of a good and if price decreases the quantity supplied decreases, but quantity demanded increases (it seems to be a normal situation because it is following supply and demand laws).
How do you think which price of bananas is most possible to be set? Okay, let’s study each case. When price is at highest value (10 $) in our competitive market is formed a surplus of bananas, because willingness of buyers has decreased. So, producers are able to sell more bananas when they get higher revenue. But this price isn’t possible, since our sellers lose a big part of their goods. When the price of bananas is 9$ our buyers are willing to get more of them, but a surplus is formed too. So, again suppliers have a loss in goods produced. What about price of 6$? As you may guess it isn’t a reasonable price for our sellers, because they aren’t able to compensate all costs for production of bananas. We may see that they will be able to supply only a small quantity of bananas, so in our competitive market a shortage will be formed. Buyers will want to buy more of bananas at even higher price, so 6$ price isn’t good enough to be a final one. At price of 7$ we will get again an excess of demand for bananas. Many consumers who want to buy bananas won’t be able to get them at this price. So they may even pay more for 1 kilogram of bananas. As you may guess the best price to be set for 1 kg of bananas in our competitive market is 8$, because at this point our supply and demand equalize each other.
The price at which no shortages or surpluses are formed is called market-clearing or equilibrium price. Quantity at each quantity supplied and quantity demanded equalize each other is call equilibrium quantity, in our case it’s 6000 kg. Graphically, the intersection of demand curve and supply curve for a good indicates market equilibrium.
Rationing Function of Prices
Competitive market has the ability to establish a final price which is convenient for both suppliers and demanders, it’s called rationing function of prices. Why is this possible? It’s quite easy to explain, at some value of price there won’t be formed any shortages which may affect negatively buyers, nor big surpluses which are burdensome for suppliers. In our case, when the price will have the value of 8$ all consumers will be able to get goods they need, and each supplier will be able to sell its products. All supplier who won’t set their price to 8$ won’t be able to get their products sold.
SURPLUS-The amount by which the quantity supplied of a product exceeds the quantity demanded at a specific (above-equilibrium) price.
SHORTAGE-The amount by which the quantity demanded of a product exceeds the quantity supplied at a particular (below-equilibrium) price.
EQUILIBRIUM PRICE-The price in a competitive market at which the quantity demanded and the quantity supplied are equal.
EQUILIBRIUM QUANTITY- The quantity demanded and supplied at the equilibrium price in a competitive market.
RATIONING FUNCTION of PRICES- The ability of market forces in a competitive market to equalize quantity demanded and quantity supplied and to eliminate shortages via changes in prices.