Supply and Demand in
Highly Competitive
Industries
Demand and supply analysis helps us understand the behavior of highly
competitive industries. This analysis is not appropriate for industries that are
not highly competitive. This limited applicability of supply and demand
analysis—to only the highly competitive situation—is important to underline
because some people incorrectly use supply and demand analysis for industries
and/or markets that are not highly competitive.
Firms in highly competitive industries are subjected to “market forces.”
Each firm is at the mercy of large number of fickle consumers who will switch
to another seller at the snap of a finger. Each firm is just one of a large number
of similar firms fighting for sales and profit.
These two factors—fickle consumers and numerous competitors—are
together the “market forces” firms face in highly competitive industries.
These market forces in highly competitive industries are represented by
using “supply and demand analysis.” This analysis shows use three things
• how market forces set prices (in highly competitive markets),
• how markets respond to changes in their environment, and
• how individual firms are at the mercy of market forces in highly
competitive markets.
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Supply and Demand in Highly Competitive Markets
SHORTAGE, SURPLUS, AND EQUILIBRIUM
In monopoly and oligopoly markets, firms set the price for their good. These
firms certainly take into account the demand curve, but the firms are the active
price setters and not an anonymous set of market forces.
In highly competitive markets no single firm, or even group of firms, has the
ability to set prices for the market as a whole or even for the price of what they
sell. Rather, the price in highly competitive markets is set by the interaction
between buyers and sellers.
No one oversees the price setting process in a highly competitive process.
Yet, as you will soon see, a simple process exists that sets the price in a highly
competitive market although no one has any oversight over the price.
That is, the apparent anarchy in a highly competitive market does not lead
to unpredictable, unstable outcomes. It often leads to a very stable outcome.
To understand how this comes about, three terms must be introduced.
SHORTAGE
Suppose that on a given day in a tomato market, sellers bring 1,000 tomatoes
to sell. On the same day, buyers want to buy 1,500 tomatoes. The amount that
buyers want to buy exceeds the amount that sellers have to sell.
When this happens, we say that a shortage exists in the market. People want
to buy more than is available.
SURPLUS
Suppose that on the next day in the tomato market, sellers bring 1,400
tomatoes to sell. On the same day, buyers want to buy 1,200 tomatoes. The
amount that buyers want to buy falls short of the amount that sellers have to
sell.
When this happens, we say that a surplus exists in the market. People want
to buy less than is available.
EQUILIBRIUM
Suppose that on the third day in the tomato market, sellers bring 1,300
tomatoes to sell. On the same day, buyers want to buy 1,300 tomatoes. The
amount that buyers want to buy exactly equals the amount that sellers have to
sell.
When this happens, we say that equilibrium exists in the market. People
want to buy the amount that sellers have to sell.
Supply and Demand in Highly Competitive Markets
217
SHORTAGE, SURPLUS, OR EQUILIBRIUM?
At any given time, a market experiences one of the above three situations: a
shortage, a surplus, or equilibrium. Yet only one of these situations will tend to
persist.
THE MOVE TOWARD THE EQUILIBRIUM PRICE
What determines whether a market has a shortage or a surplus or if the market
is in equilibrium? Three things determine this: the price, the demand curve, and
the supply curve.
At any given price, the demand curve indicates how much people want to
buy. At any given price, the supply curve indicates how much sellers—in this
case firms—want to sell.
In Figure 1, the $5 price gives rise to a shortage. At this $5 price, buyers
want to buy 350. However, at this price firms only want to sell 300. A shortage
of 50 exists.
Figure 1
Price
S
$5
D
300
350
Quantity
In this shortage situation, some of the buyers who are unable to get what they
want might be willing to pay more than $5 for the good. At the same time,
firms notice that a shortage exists and that some buyers will not be able to buy
what they want. Therefore, some firms think about taking advantage of the
shortage by raising their price above $5.
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Supply and Demand in Highly Competitive Markets
That is, a shortage gives to sellers (firms) bargaining power. Firms use this
bargaining power to benefit themselves by pushing up the price.
In Figure 2, the price of $10 leads to a demand of 200 and a supply of 500.
At $10, then, a surplus of 300 exists (500 – 200).
Figure 2
Price
S
$10
D
200
500
Quantity
Some sellers seeing that they might be unable to sell what they have brought to
market consider accepting less than $10 for their good. And, buyers noticing
that sellers will have unsold goods at $10 think about bargaining for a lower
price.
A surplus gives bargaining power to buyers. And, buyers use this bargaining
power to push down the price of the good in the market.
In a shortage, the price will rise. When a surplus exists, the price will fall.
But where will the price go in these two situations?
Consider Figure 3. Equilibrium exists in this figure. The price of $7 gives
rise to a demand of 325. It also gives rise to a supply of 325. Demand equals
supply: no surplus exists and no shortage exists. The market is in equilibrium.
This $7 price is called the “equilibrium price” as it gives rise to an equilibrium
situation in the market.
Supply and Demand in Highly Competitive Markets
219
Figure 3
Price
S
$7
D
325
Quantity
Once the price reaches the equilibrium, no one has bargaining power because
neither a shortage nor a surplus exists.
In a shortage, the price will rise until it reaches the equilibrium price. When
a surplus exists, the price will fall until it reaches the equilibrium price.
This price—the equilibrium price—will be the price towards which a highly
competitive market will move and will eventually reach. If the price is above the
equilibrium, then a surplus exists and the price will fall. If the price is below the
equilibrium a shortage will exist and the price will rise.
CHANGES IN EQUILIBRIUM PRICE AND QUANTITY
At equilibrium, the intensions of buyers and sellers are in synch. In particular,
at the equilibrium price the quantity demanded equals the quantity supplied.
Once a market reaches equilibrium, the price and quantity in the market will
stay the same. Or, they will if nothing changes in the market.
But things do changes in markets almost every day. Some events cause the
demand curve to move. Other events cause the supply curve to move. If either
the demand curve or the supply curve moves, the old equilibrium is now a
“disequilibrium” and the price will adjust to a new equilibrium.
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Supply and Demand in Highly Competitive Markets
A CHANGE IN DEMAND
Figure 4 portrays equilibrium: the demand curve D and the supply curve S
intersect to give an equilibrium price of $7 and quantity of 325.
Figure 4
Price
S
$7
D1
D
325
450
Quantity
But suppose that something causes the demand curve to shift right—perhaps
consumers’ income grows or people come to like the product more than before.
As you can see, the old equilibrium of $7 and 325 is not longer where the (new)
demand curve D1 and the supply curve (S) intersect.
In particular, at the old price of $7 we now have a shortage. At $7 the
supply is equal to 325 but the demand (because of its rightward shift) is now at
450. This shortage will give bargaining power to sellers, they will use this
bargaining power to increase prices, and the price will start to rise.
As the price rises supply expands as firms move up the supply curve. And, as
the price rises, buyers move up along the demand curve. This is illustrated in
Figure 5.
Supply and Demand in Highly Competitive Markets
221
Figure 5
Price
S
$9
$7
D1
D
325
400
450
Quantity
The price will continue to rise until it reaches $9. At the new price, the quantity
supplied equals the quantity demanded and we have a new equilibrium of $9
and 400 output. If any of the various determinants of demand change, they
cause the demand curve to move right or left.
A CHANGE IN SUPPLY
Figure 6 portrays the same equilibrium as above. The demand curve D and the
supply curve S intersect to give an equilibrium price of $7 and an equilibrium
level of output 325.
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Supply and Demand in Highly Competitive Markets
Figure 6
Price
S
S1
$7
D
325
400
Quantity
But now suppose that something causes the supply curve to shift right—perhaps
wages fall or productivity grows. As before, the old equilibrium of $7 and 325
is no longer where the demand curve D and the new supply curve (S1) intersect.
In particular, at the old price of $7 we now have a surplus. At $7 the
demand is equal to 325 but the supply (because of its rightward shift) is now at
400. This surplus will give bargaining power to buyers and they will use this
bargaining power to push down prices. Firms fearful of being left with unsold
goods go along with the price decline, and the price will start to fall.
As the price falls, the quantity supplied contracts as firms move down the
supply curve. And, as the price falls, buyers move down along the demand
curve.
This is illustrated in Figure 7.
Supply and Demand in Highly Competitive Markets
223
Figure 7
Price
S
S1
$7
$5
D
325
350
400
Quantity
The price will continue to fall until it reaches $5. At the new price, the quantity
supplied equals the quantity demanded and we have a new equilibrium of $5
and 350 output.
If any of the determinants of the supply curve change, they cause the supply
curve to move right or left.
SIMULTANEOUS CHANGES IN DEMAND AND SUPPLY
If only one curve moves at a time, it is easy to predict the direction of price and
output changes. But if both supply and demand move at the same time, then it
becomes much trickier to predict what will happen. However, some predictions
can be made.
In Figure 8, both the supply and demand curves move to the right. Demand
moves from D to D1 while supply moves from S to S1. As drawn, the price will
rise and output grows from $7 and 325 to $8.15 and 450.
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Supply and Demand in Highly Competitive Markets
Figure 8
Price
S
S1
$8.15
$7
D1
D
325
450
Quantity
In Figure 9, both the supply and demand curves again move to the right.
Demand moves from D to D1 while supply moves from S to S2. But in this
case, the supply curve moves a larger distance than it did in Figure 8. Whereas
in the above figure the price rose, here it falls from $7 to $6.70. As before, the
quantity bought and sold in the market grows.
Supply and Demand in Highly Competitive Markets
225
Figure 9
Price
S
S2
$7
$6.70
D1
D
325
540
Quantity
I
n this case of both curves moving to the right, the output will grow. However,
whether the price rises or falls depends on the relative size of the movements of
the two curves. In some cases, the price will rise; in other cases the price will
fall.
It turns out that when both curves move at the same time, only one of the
changes in price or quantity can be predicted. The student should try all the
possible combinations (moves to right/left of D combined with moves to
right/left of S) to discover what type of patterns exist in price and quantity
movements when two curves move at the same time.
THE RULE OF ONE
For the purposes of learning supply and demand analysis in this class, you
should remember the Rule of One:
One Event causes One Curve to move One
Time in One Direction
In the “real world,” however, this rule of one might not always be true.
And, in this class one important violation of the Rule of One will be discussed:
the impact of widespread changes in wages.
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Supply and Demand in Highly Competitive Markets
But, other than that exception, even if two events happen at the same time,
each individual event only causes one curve to move one time in one direction.
The one exception to the rule of one will be discussed in class: widespread
changes in wages. This situation violates the rule of one because widespread
changes in wages affect both the supply curve (as wages are a cost) and the
demand curve (as wages are a key source of income). However, other than this
one exception, it is reasonable to assume that the rule of one holds true for the
simple sort of supply and demand problems considered in introductory
microeconomics.
CHARACTERISTICS OF THE EQUILIBRIUM PRICE IN A
COMPETITIVE MARKET
The equilibrium price in a highly competitive market is the lowest it can be. If
the price is “high” then profits will also be high for the firms in the industry.
But because barriers to entry for highly competitive industries are very low,
outsiders will enter this industry to earn some of these high profits.
As these new firms enter the industry, the supply curve will shift to the right.
This rightward shift of the supply curve pushes the industry price down. Firms
will continue to enter the industry as long as the profit earned by industry firms
is better then outsiders can earn elsewhere. That is, the supply curve will shift to
the right until the price falls to a level giving firms in the industry a relatively
low profit rate. The price will be as low as possible in this industry.