The demand curve of the perfectly competitive firm

After you have worked through this section of the learning unit, you should be able to:

  • derive the demand curve for a perfectly competitive firm

Let's assume that the market for fried chicken pieces is a perfectly competitive market. There are many buyers and sellers in this market, the suppliers produce a homogeneous good, there is no collusion between the sellers and buyers, and firms are free to enter and exit the market as they wish. In addition, we also assume there is perfect knowledge about market conditions, there is no government intervention in the market, and the factors of production in the market are perfectly mobile.

In this market, suppliers of fried chicken pieces are price takers. A price taker is a firm that has no control over the price at which it is able to sell its product. But how do firms know which price they are supposed to "take" or charge?

In a perfectly competitive market, the price of a product is determined by the forces of market demand and market supply; and the price is set at such a level that the quantity demanded is equal to the quantity supplied. In terms of the demand and supply curves, this occurs where the market demand and the market supply curves intersect. Do you remember how the market equilibrium price is determined? If not, refer back to the unit on market equilibrium.

Market for Fried Chicken Pieces

Let's take a closer look at what it means for an individual firm to be a price taker.

As an example, we will use Funky Chicken, which is a supplier of fried chicken pieces in the market for fried chicken pieces.

The market for fried chicken, which is represented in diagram A, consists of the market demand and market supply of fried chicken pieces. Given this market demand and market supply, the equilibrium price is established at R4 and the equilibrium quantity at 100 000 fried chicken pieces.

In diagram B, the position of the individual supplier of fried chicken pieces, Funky Chicken, is represented. Since Funky Chicken is a price taker, it has to take the price of R4 as given and sell its fried chicken pieces at R4. By extending the market price of R4 to diagram B as a horizontal line, the demand curve facing the individual firms is derived. This demand curve is perfectly elastic and indicates that Funky Chicken can sell any quantity at a price of R4. Remember that Funky Chicken has a small market share since there are many sellers in the market.

Why can it not sell chicken pieces for R5? It is selling the same product as other suppliers, and since buyers know that they can obtain a piece of fried chicken for R4, nobody would be prepared to buy it for R5. Why not sell a piece of fried chicken for R3? Because Funky Chicken knows that it can sell all its fried chicken pieces for R4, and because it wishes to maximise its profits, it would be irrational for the business to sell it for R3 if it can obtain R4 for a piece of fried chicken.