How are prices determined in perfectly competitive markets? In perfectly competitive markets, prices are determined by
A. consumers because firms individually are very small relative to the market.
B. the interaction of market demand and supply because firms and consumers are price takers.
C. consumers because firms sell identical products.
D. firms because they each have market power.
E. firms because they sell differentiated products.
The correct answer and explanation is:
The correct answer is B. the interaction of market demand and supply because firms and consumers are price takers.
In perfectly competitive markets, the prices of goods and services are determined by the forces of supply and demand. These markets are characterized by several key features. First, firms are price takers, meaning they do not have any market power to set prices. This is because the products they sell are identical, and consumers can easily switch from one firm to another without any preference. Since firms are small relative to the market, no single firm can influence the price.
In such markets, the price is determined by the interaction between the market demand and the market supply. When demand for a product increases, the price tends to rise, and when demand decreases, the price falls. Similarly, if there is an increase in supply, prices may decrease, while a decrease in supply can cause prices to increase. Firms adjust their output levels in response to these price changes, but they accept the prevailing market price.
Because all firms produce identical goods, and there are no barriers to entry or exit, the market forces of supply and demand ensure that the price gravitates towards a level where quantity demanded equals quantity supplied. In the long run, firms in a perfectly competitive market can only earn normal profits (zero economic profit) because any economic profits would attract new firms, increasing supply and driving the price down until profits are eliminated.
Consumers play a role in shaping demand, but it is the overall interaction of demand and supply that ultimately determines the price in a perfectly competitive market. This dynamic leads to efficient allocation of resources where goods are produced at the lowest possible cost.