While explaining the price equilibrium state, we have specified the perfect competition in the market to be the most important condition to achieve the equilibrium situation demand equals to supply at the optimum price level.
To understand the rationale behind the same let us consider a situation of no competition in the market. Will it be possible to sustain the price equilibrium situation? Let us find that out for a popular industry like steel industry…
There are couples of big players (mainly Tata Steel, SAIL, Essar Steel, Jindals etc.) in the steel industry market and the perfect competition exists. The perfect competition leads to price equilibrium state where supply is equal to demand. The state remains with increase in supply with increased demand and decrease in supply with decreased demand. For both of the movement, price remains same. The below graphs explains the same.
Suppose in the above pic, the Equilibrium demand and supply lines are denoted by thick lines which are intersecting with each other at Price P*. This is the Equilibrium price.
Now if Demand is decreased (denoted by Demand Line D1) in the market, all the steel producing companies will decrease the Supply as well (denoted by Supply Line S1) to keep the price same as equilibrium price P*. Both the lines are intersecting at point “A” in the above picture to keep the price at equilibrium price P*. The same way if Demand is increased (denoted by Demand Line D2) in the market, all the steel producing companies will increase the Supply as well (denoted by Supply Line S2) to take care of the additional demand to keep the price same as equilibrium price P*. Both the lines are intersecting at point “B” in the above picture to keep the price at equilibrium price P*. This is how the perfect competitive market works.
Here the most important point is that all the steel producing companies are producing the same quality of steel and there is no difference between their products. Consumers should not have any preference for any company in the system. If they prefer one company because of better quality, they will pay more than the equilibrium price to get the same.
What can the scenario here if Tata steel could have been the only Steel producer and it supplies all the steel in the market as per the demand?
It will reduce the supply of steel artificially to inflate the price because of higher demand and continue to do so. It will continue to supply steel lower than demand to keep the price inflated for all the time to earn more profit. No competition in the market provides the benefit for the supplier to earn extra profit and all the buyers lose money in this case. With perfect competition, if Tata Steel reduces the steel production, some other player will increase the production and supply to keep the price stable.
Basic fundamentals for perfect competition
Market competition can further be divided in some categories like Monopolistic competition and Oligopoly.