Objective of Customers and Firms
•A perfectly competitive market consists of buyers and sellers who are driven by their self-interested objectives.
•The objectives of the consumers are to maximise their respective preference and utility.
•The objectives of the firms are to maximise their respective profits.
•Both the consumers’ and firms’ objectives are compatible in the equilibrium.
•An equilibrium is defined as a situation where the plans of all consumers and firms in the market match and market supply equals market demand.
•In equilibrium, the aggregate quantity that all firms wish to sell equals the quantity that all the consumers in the market wish to buy;
•The price at which equilibrium is reached is called equilibrium price and the quantity bought and sold at this price is called equilibrium quantity.
Conditions of Equilibrium
•If p* denotes the equilibrium price, and
•qD(p*) and denote the market demand
•qS(p*) denotes the market supply of the commodity respectively at price p*.
•Then (p*, q*) shall be in equilibrium if qD(p*) = qS(p*)
Excess Supply and Demand
•Excess Supply: If at a price, market supply is greater than market demand, we say that there is an excess supply in the market at that price
•Excess Demand: If market demand exceeds market supply at a price, it is said that excess demand exists in the market at that price.
•Therefore, equilibrium in a perfectly competitive market can be defined alternatively as zero excess demand-zero excess supply situation.
•Whenever market supply is not equal to market demand, and hence the market is not in equilibrium, there will be a tendency for the price to change.
•Adam Smith (1723-1790) is often called “The Father of Economics'' or ''The Father of Capitalism''.
•He maintained that in a perfectly competitive market an ‘Invisible Hand’ is at play which changes price whenever there is imbalance in the market.
•It should raise the prices in case of ‘excess demand’ and lower the prices in case of ‘excess supply’.
•This ‘Invisible Hand’ by following this process is able to reach the equilibrium.
Concept of Invisible Hand
•The phrase invisible hand was introduced by Adam Smith in his book 'The Wealth of Nations'.
•He assumed that an economy can work well in a free market scenario where everyone will work for his/her own interest.
•He explained that an economy will comparatively work and function well if the government will leave people alone to buy and sell freely among themselves.
•He suggested that if people were allowed to trade freely, self interested traders present in the market would compete with each other, leading markets towards the positive output with the help of an invisible hand.
How invisible Hand works
•In a free market scenario where there are no regulations or restrictions imposed by the government, if someone charges less, the customer will buy from him.
•Therefore, you have to lower your price or offer something better than your competitor.
•Whenever enough people demand something, it will be supplied by the market and everyone will be happy.
•The seller end up getting the price and the buyer will get better goods at the desired price.