Price Determination under Perfect Competition
ALLAMA IQBAL EXPLAINS
Translated from Urdu Ill-mul-Iqtisad
By: Abbas Ali
………….In the aforementioned example, the meanings of the laws of demand and supply are explained; however, the question remains as to how the balance between demand and supply is established. We used the term competition, whose meaning needs to be kept in mind. Because of the effect of competition, a balance between demand and supply is established. Therefore, before explaining how the afore-mentioned balance is established through the process of competition, it is pertinent to explain its meaning in the first place. This term refers to the competition or business tug of war that occurs between the buyers and sellers of a commodity.
Because everyone has the motive of giving the minimum and acquiring the maximum. The process of competition is against mutual unity, custom, and human effects. By nature, every person works for himself. He has the freedom to sell his goods wherever he wants. The restrictions of custom cannot compel him to sell at any specific place, and by nature, every person aims for his personal benefit and profit. He does not care about any other person’s loss. This is the economic meaning of the term competition.
To understand its meaning, let us ponder over the above-mentioned example. We stated above that fertilizer sellers will keep decreasing prices due to competition. If two measures of grain are offered per truck, then the demand and supply will be unequal. Because the supply of fertilizer is ten thousand trucks, but the demand is five thousand trucks. If the price is further decreased, the supply will perhaps come down to nine thousand trucks. Because many fertilizer sellers will leave the job of selling fertilizers and engage in some other job.
Supposing a farmer thinks that by using more fertilizer than the fixed amount of fertilizer, the production from the land will reimburse the price of the additional amount of fertilizer used, this kind of thinking will provoke him to buy more fertilizer; hence, the demand for fertilizer, which was five thousand trucks earlier, will perhaps increase to six thousand trucks. According to the same theory, if the price decreases, the supply will also decrease. Initially, the supply was ten and the demand was five; the supply became nine and the demand six. Similarly, perhaps the demand will rise to seven and the supply to eight. Therefore, both quantities will come closer because of competition. Suppose that when the ratio of demand and supply is 7:8, the price of fertilizer will stop at ½ measures of grain per 1 truck of fertilizer. Now the issue of whether the equilibrium between demand and supply will be established at some price that will be above or below the aforementioned price depends upon two factors:
1. The marginal utility of the quantity of fertilizer, which will be more than seven thousand trucks,
2. The ability of fertilizer sellers to adopt any other beneficial job
Supposing a farmer buys ten trucks of fertilizer at 2 ½ measures of grain per truck of fertilizer, then the same will be established as the price. It is subject to the condition that no other fertilizer seller is ready to sell at a lower price.
However, if this farmer gets the fertilizer at 2 ¼ measures of grain per truck of fertilizer, then perhaps he might buy even five trucks of fertilizer. If it is possible, then the marginal utility of fertilizer will be determined by 2 ¼ measures of grain, and the same will determine its price per truck. Similarly, if he gets more fertilizer at 2 measures of grains per truck of fertilizer, then marginal utility will be determined by the same price. According to the same theory, if more fertilizer is available at 1 ½ measures of grain per truck of fertilizer, the same price will be established. In the same manner, the farmer will be able to buy twenty trucks of fertilizer.
However, it is obvious that different parts of fertilizer have different uses. If the farmer buys twenty trucks of fertilizer at the same time, he will have to pay an equal price of 1 ½ measures per truck. Because the price of the same commodity is determined by its marginal utility and is generally equal, it is subject to the condition that competition is in full effect. There is no doubt about the fact that some factors create differences in the price of commodities. However, we will discuss these factors later. At this point in time, we want to explore why the retail price of a commodity is different from the wholesale price of the same commodity in the market.
There are many interpretations of the word “market.” It is obvious that every commodity has some market, e.g., market for iron, market for tea, etc. According to the same theory, in the same area, there are various parties who exchange the same commodity. It is possible that among them, the price of the same product is different. Therefore, the word market refers to all those people whose demand or supply affects the price of a particular commodity at some particular place. If the competition is perfect, then the price of any commodity will always be closer to the cost of production of that commodity.
In other words, the supply of the commodity will depend upon the cost of production of that part that has been produced in favorable conditions, and this price will be the measure of its marginal utility. More explicitly, this price is the measure of the marginal utility of that part that a consumer is ready to buy without any apprehension of loss. Additionally, this price will make up for the struggles and difficulties that the producers of these goods have faced while working in extremely unfavorable conditions.
But, because all the buyers will pay an equal price for the commodity, obviously, those who produced it in favorable conditions will benefit. In other words, their reward will be greater than the efforts and difficulties that are related to the production of the commodity. And for the people who produced the commodity in unfavorable conditions, their reward will be hardly equal to their efforts and difficulties. For example, suppose that some people work in extremely favorable conditions, or, in other words, they dig at a mine where a huge amount of iron is extracted with meagerlabor and capital. Obviously, these people will get much more benefit as compared to those who do the same job in unfavorable conditions, or, in other words, dig a mine where extracting iron requires huge labor and capital. The reason for the benefit of the former is that the buyers will be ready to buy the commodity at an equal price, which will be profitable for the first party, and the second party will hardly get it as part of the cost of production.
If the competition is perfect among the iron sellers, the price of iron will gradually come closer to its cost of production. This price, which comes closer to the cost of production due to competition, is called the normal price in the terminology of economics. However, because competition does not work perfectly, every economic good has a particular price in the market, which is known as the introduced price in terminology, and this price is more or less different from the normal price because, generally, through it we cannot estimate the cost of production, although for a consumer we can estimate his marginal utility for the commodity. The difference between the normal price and the introduced price is based on the following causes:
1. The stock of a commodity that is present in the market It is pertinent to remember that stock and supply are not synonymous. Stock refers to the total amount of the commodity that is present in the market at a particular time, and supply refers to that amount of the stock that is offered for sale even if it is not physically present in the market. Therefore, it is possible that supply is a small part of the stock. For example, when a commodity fetches a lower price, naturally, the shopkeeper will not offer the entire stock for sale but only a small part of it, which in that case will be called the supply. When the price rises, he will offer more from his stock as compared to the earlier amount. Hence, with the increase in price, the stock will transform into supply.
Contrarily, it is also possible that in some markets, supply can be greater than stock. For example, business brokers make a contract with the buyers that they will make available huge quantities of grain, bread, etc. However, in actual terms, the contracted items are either not physically available at all or are available in small quantities. Because the demand of the consumers is not related to the daily production of the goods but to the stock of the goods, it is possible that the increase and decrease in the stock of the goods might cause a difference between the introduced price and the normal price. For example, if, during some years, due to a decrease in supply, the price of grain increases, in the next year, if there is an increase in production, it is possible that the price will decrease below the current price.
However, sometimes it happens that if the supply of grain is low, people substitute it with corn. In this case, the fluctuation in the stock of the grain cannot affect its price. According to the same theory, some goods can be stored, and some goods have no capability of being stored. This also affects the introduced price. For example, for some goods like fish, etc. (which cannot be stored), their price in the market varies from morning to evening.
2. Entrepreneurship and the technique of production make it difficult for labor to transform into some other profession and for capital to transform into some other form. It is the second reason for the difference between the normal price and the introduced price. According to Alfred Marshall, “in the professions that use huge fixed capital, the price of the commodities in these professions tends to change substantially.”
You must remember that during the explanation of demand and supply, we provided the example of fertilizer suppliers. The purpose of providing such an example was to show that in the mentioned profession, the second reason for the difference between the normal price and the introduced price cannot cause any effect. Because neither big production techniques nor skilled professionals whose labor can be transformed into some other profession are required,
3. Sometimes customs, traditions, and laws also determine the introduced price of the commodities. In addition to it, sometimes the habits and nature of the professionals also affect the increase or decrease of the price. When the daily wages of some craftsmen are fixed once, they remain the same for years, even though the number of craftsmen increases as compared to the previous number. You might have heard of the maulvis who solemnize Rs 1 ¼ for their services. These cases are exceptions to the law of marginal utility, and price is determined by custom. A father might be ready to pay thousands of rupees to save the life of his sick son, but because of custom, he must pay only Rs 2/= as an offering.
There are some ethical reasons for the difference between the introduced price and the normal price. For example, sometimes, in anticipation of an increase in price, the shopkeepers do not bring their stock of goods for sale to the market. Even with the expectation of profit, sometimes they face losses.
In the case of retail sales, it is more important to ponder these ethical causes. We have stated earlier that even in the same market, similar goods receive equal prices; however, some causes work against this equation. Generally, consumers are not intelligent enough to understand the real value of buying goods. Therefore, considering them naive, the shopkeeper sometimes deceives them by selling the goods at higher prices.
Because all the shopkeepers do not act like that, sometimes it happens that in a market, at the same kind of price, the equation does not remain intact. According to some writers, custom rather than competition determines the price of commodities in retail sales, so it is generally true that retail sellers should set their prices in accordance with moral and ethical standards to prevent price reductions from a business standpoint. This is the reason that, according to some thinkers, retail selling is not based on economic principles but on ethical principles.
There is no doubt about the fact that it is true under special circumstances. But there is also no doubt about the fact that even this part of business is not exempt from competition.
Ilm-ul-Iqtisad
Part-3 Chapter-1
Baab Awal “Masl-e-Qadir”
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