Q27 — Determination of Market & Normal Price under Perfect Competition

Introduction

Price occupies a central place in microeconomic theory. Under perfect competition the mechanism of demand and supply operates in its purest form and determines both the market price (short-period price) and the normal price (long-period price). In the prescribed text “Microeconomics” by T.R. Jain & V.K. Ohri, the determination of these prices is explained by combining the demand–supply approach with the theory of costs and laws of returns.

This answer, in line with Panjab University expectations, first clarifies the concepts of market price and normal price, then explains their determination under perfect competition with the help of diagrams, and finally analyses the effect of laws of return on normal price in different types of industries.

I. Meaning of Market Price and Normal Price

1. Market Price

Market price is the actual price ruling in the market at a particular point of time or during a very short period (market period/short period). It is determined by the immediate interaction of demand and supply, given:

Existing stock of the commodity, and
Short-period demand of buyers.

Market price may fluctuate from day to day or even hour to hour due to short-term changes in demand and supply.

2. Normal Price

Normal price is the long-period equilibrium price toward which the actual market price tends to move. It is the price which is just sufficient to cover:

Long-run average cost of production, including
Normal profit of the entrepreneur.

In the long period, firms can vary their scale of production and new firms can enter or old firms can leave the industry. Therefore, normal price is determined by long-run demand and long-run supply, the latter being governed by the laws of return (cost conditions).

In short:
Market price = Actual, short-period price determined by current demand and supply.
Normal price = Long-period price determined by long-run demand and supply, covering normal profit.

II. Basic Assumptions of Perfect Competition

For a proper understanding of price determination under perfect competition, we recall the key assumptions:

Large number of buyers and sellers — no individual can influence market price.
Homogeneous product — units of the commodity are identical.
Free entry and exit of firms in the long run.
Perfect knowledge about prices and conditions of the market.
Perfect mobility of factors of production.
No selling costs and generally uniform technology.

Under these conditions, the industry determines the price and each firm is a price-taker.

III. Determination of Market Price under Perfect Competition

1. Demand and Supply Approach

In the short period, the stock of the commodity is more or less given and the number and size of firms are fixed. Market price is determined by:

The market demand curve (D), showing quantities demanded at various prices.
The market supply curve (S), showing quantities firms are willing to supply at various prices.

The intersection of demand and supply determines the equilibrium market price and equilibrium quantity.

Fig. 1 — Determination of market price under perfect competition: market demand (D) and market supply (S) intersect at E₀, giving equilibrium price P₀ and quantity Q₀.

At price P₀, the quantity buyers wish to purchase equals the quantity firms wish to sell (Q₀). If price were higher than P₀, supply would exceed demand and competition among sellers would force price down; if price were lower than P₀, demand would exceed supply and competition among buyers would push price up. Thus P₀ is the market-clearing price.

2. Relationship between Market Price and Cost

For individual competitive firms, P₀ is taken as given. Each firm adjusts its output where:

P₀ = MR = MC

At this price some firms may earn supernormal profits, some may earn normal profits, and some may incur losses, depending on their cost conditions. But the market price itself is determined by demand and supply, not directly by cost.

IV. Determination of Normal Price under Perfect Competition

Normal price is a long-run concept. In the long run:

All factors are variable.
Firms can change their scale of plant.
New firms are free to enter and existing firms are free to exit.

Therefore, if firms are earning supernormal profits at the prevailing price, new firms enter, industry supply increases, and price falls. If firms are incurring losses, some firms exit, industry supply decreases, and price rises. This process of entry and exit continues till firms earn only normal profits.

1. Long-run Equilibrium Conditions

For a competitive industry in long-run equilibrium:

Market demand equals long-run market supply.
Each firm produces at the output where MR = MC (profit maximisation condition).
Since P = AR = MR under perfect competition, and free entry–exit drives supernormal profits to zero, long-run equilibrium requires:
P = AR = MR = minimum LAC

Thus normal price is the price equal to minimum long-run average cost (LAC) of the representative firm, ensuring only normal profit.

2. Diagrammatic Determination of Normal Price

_N P_N E_N Cost/Revenue Firm Output (q) (b) Firm q_N E_f P_N = min LAC

Fig. 2 — Normal price under perfect competition: industry equilibrium at P_N where D and long-run supply (LRS) intersect; firm’s equilibrium where P_N = minimum LAC = LMC. Only normal profit is earned.

At price P_N:

Industry’s quantity supplied equals quantity demanded (long-run equilibrium of industry).
Each firm produces at the minimum point of its LAC curve, where LMC = LAC = P_N.
Firms earn normal profit and there is no incentive for entry or exit.

V. Effect of Laws of Return on Normal Price

In the long run, the cost conditions of the industry depend on the laws of returns to scale. As the industry expands, production may take place under:

Increasing returns to scale (decreasing cost industry),
Constant returns to scale (constant cost industry), or
Decreasing returns to scale (increasing cost industry).

These different cost conditions affect the shape of the long-run supply curve and therefore the behaviour of the normal price as industry output expands.

1. Decreasing Cost Industry (Increasing Returns to Scale)

In a decreasing cost industry, when the industry expands output in the long run:

Firms enjoy economies of scale (technical, managerial, marketing, financial, etc.).
External economies (improved infrastructure, specialised labour, etc.) also reduce costs.
As a result, long-run average cost (LAC) falls as industry output increases.

Hence the long-run supply curve slopes downward. When demand increases, the new long-run equilibrium is established at a lower normal price and higher output.

Fig. 3 — Decreasing cost industry: an increase in demand from D₁ to D₂ leads to a larger output (Q₂ > Q₁) and a lower normal price (P₂ < P₁) because the long-run supply curve slopes downward.

Thus, under increasing returns to scale (decreasing cost), expansion of the industry reduces normal price in the long run.

2. Constant Cost Industry (Constant Returns to Scale)

In a constant cost industry:

Expansion of industry output does not significantly change factor prices or technology.
Internal and external economies are exactly offset by diseconomies.
Therefore, LAC remains constant as output expands.

In this case the long-run supply curve is horizontal at the level of minimum LAC. When demand increases, the new long-run equilibrium is established at the same normal price but higher quantity.

Hence, under constant returns to scale, normal price remains unchanged as the industry expands; only output and number of firms change.

3. Increasing Cost Industry (Decreasing Returns to Scale)

In an increasing cost industry:

As the industry expands, it faces diseconomies — higher factor prices, congestion, management difficulties, etc.
External diseconomies may arise due to pressure on infrastructure and limited specialised resources.
Consequently, LAC rises as industry output increases.

The long-run supply curve in this case slopes upward. With an increase in demand, the new long-run equilibrium is attained at a higher normal price and higher output.

Thus, under decreasing returns to scale, normal price rises when the industry expands.

Summary of the Effect of Laws of Return on Normal Price

Decreasing cost (increasing returns) industry: LAC falls with output; long-run supply slopes downward; normal price falls as industry expands.
Constant cost (constant returns) industry: LAC constant; long-run supply horizontal; normal price unchanged as industry expands.
Increasing cost (decreasing returns) industry: LAC rises with output; long-run supply slopes upward; normal price rises as industry expands.

VI. Combined View: Market Price, Normal Price and Laws of Return

We can now combine the analysis:

In the short period, market price is determined by current demand and supply. It may be greater or less than the normal price and can fluctuate frequently.
In the long period, competitive forces of entry and exit drive the price toward normal price, at which firms earn only normal profits and produce at minimum LAC.
The laws of return (cost conditions) decide how the long-run supply curve behaves and thus whether normal price, in the face of growing demand, falls, remains constant or rises.

Exam Tip (for 15 marks): To secure full marks in Panjab University B.Com (Sem I), write this answer in four clear parts: (i) precise meanings of market price and normal price; (ii) determination of market price under perfect competition with a demand–supply diagram; (iii) determination of normal price using long-run demand, long-run supply and the condition P = minimum LAC for a competitive firm; and (iv) a structured discussion of the effect of laws of return (decreasing, constant and increasing cost industries) on normal price. Support your answer with neat, well-labelled diagrams and finish with a brief summary paragraph.

Conclusion

To conclude, under perfect competition the market price is determined in the short period by the intersection of market demand and market supply, while the normal price is the long-period equilibrium price at which firms produce at the minimum of their LAC and earn only normal profits. The laws of return — reflected in the shape of the long-run cost curves — determine whether, as the industry expands, the normal price tends to fall (decreasing cost industry), remain constant (constant cost industry) or rise (increasing cost industry). This integrated treatment of price determination is exactly in line with the traditional competitive model as presented in T.R. Jain & V.K. Ohri and is of high examination value for B.Com Semester I students.

These notes form part of a carefully curated set of important questions which have frequently appeared in past university examinations and therefore carry a high probability of being reflected, in whole or in part, in future question papers. However, they are intended as high-quality academic support material only and should not be treated as a guarantee or assurance of any specific questions being asked in forthcoming exams.