QUESTION 2 [25 marks]
Discuss how a perfectly competitive market determines its equilibrium price and quantity in
the short run and in the long run. Use appropriate assumptions and diagrams to support your
answer. (25 marks)
In a perfectly competitive market, the equilibrium price and quantity are determined through the interaction of market demand and market supply. In the short run, the equilibrium is affected by the current market conditions, while in the long run, the equilibrium is influenced by the adjustments that occur over time.
In the short run, the equilibrium price and quantity are determined by the intersection of the market demand and market supply curves. The market demand curve represents the quantity of a good or service that consumers are willing and able to purchase at different prices, while the market supply curve represents the quantity of the good or service that producers are willing and able to supply at different prices.
Assuming there are no external factors influencing the market, the equilibrium price and quantity occur where the market demand and market supply curves intersect. At this point, the quantity demanded by consumers matches the quantity supplied by producers. The price at this equilibrium point is called the market-clearing price, as it ensures that all goods produced are sold, hence clearing the market.
Diagrammatically, the equilibrium price and quantity can be illustrated by a demand and supply graph. The demand curve slopes downwards from left to right, indicating that as price decreases, quantity demanded increases. The supply curve, on the other hand, slopes upwards from left to right, indicating that as price increases, quantity supplied increases.
In the short run, if there is an increase in demand, the demand curve shifts to the right. This leads to a higher equilibrium price and quantity, as shown in the diagram. Similarly, if there is a decrease in demand, the demand curve shifts to the left, resulting in a lower equilibrium price and quantity.
In the long run, the assumption is that factors such as production technology, input prices, and entry and exit of firms can adjust. Firms can enter or exit the market based on profit or loss. If there are profits in the market, new firms will enter, leading to an increase in supply. This causes the supply curve to shift to the right, resulting in a decrease in the market price and an increase in market quantity.
Conversely, if there are losses in the market, firms will exit, reducing supply. This causes the supply curve to shift to the left, leading to an increase in the market price and a decrease in market quantity. This process continues until all firms in the market earn normal profit, where the market supply curve intersects the market demand curve at the long-run equilibrium.
Overall, in both the short run and the long run, the equilibrium price and quantity in a perfectly competitive market are determined by the interaction of market demand and market supply. In the short run, the equilibrium is affected by current market conditions, while in the long run, the equilibrium is influenced by adjustments over time, such as firm entry and exit. Diagrams can effectively illustrate these concepts and help visualize the equilibrium outcomes in a perfectly competitive market.