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Thursday, 18 April 2013

Perfectly competitive market

Demand can be described economically as a desire for owning anything, ability to incur expenses for the item in terms of payment, and definitely the will to pay. More clearly, it shows willingness and ability to purchase a commodity at a certain time. It is recorded by economists on demand schedule and plotted characteristically downward slopping on a graph (demand curve). Generally every product that a consumer considers to buy, there exists a demand curve for that particular product and for that particular consumer. Demand curve of a consumer is always the equivalence of the marginal utility i.e. gain or loss attributed to an increase or decrease in consumption of a particular good or a particular service. Therefore the law of demand can be described as while everything else is held at constant as quantity of services or goods which are well defined that can willingly be bought by consumers in a particular time period and which increases or decreases as price for the service or good falls or rises (Epstein, 2005, p.116).
Aggregate demand curve
Aggregate demand refers to amount of goods or services which will be acquired or purchased by consumers at any given possible price level. It can be defined as the country’s Gross Domestic Product (G.D.P) when levels of inventory are static. It is described as summation of demand curves from the different economic sectors. i.e.
Y = C +J +G + NX (Perloff, 2008, p.98), given that NX = Ex – Im whereby Y describes Aggregate Demand, C describes consumption, G descries Government spending, Ex describes the total exports and Im describes the total imports therefore NX describes the net Imports.
Price Level decreases from p1 to p2


            A decrease in price level

Increase in quantity of demanded goods and services           ……... Output quantity
From y1 to y2


                A decrease in price level

In the graph above, a fall in price level to p2 from p1 leads to increase in demand to y2 from an initial y1. This is attributed to increasing wealth with a fall in the interest rates and increase in wealth.  Consumption is thus stimulated with an increase in exports and investments. The above described would thus lead to higher demand for services and goods.
Effect of falling demand on the number of firms and firms’ profitability
            Revenue derived from produced goods and services is of outmost importance to firm. Though firms may influence sales volumes, it is largely limited by demand and production capacity (Krizanova, 2006, p.221). Therefore a fall in demand will definitely cause the firms to react because this would mean a fall in their revenue collection. This fall in demand causes firms to cut back on investments and thus reduces employment.
            Fall in demand leaves the firms at a point whereby the cost of production of goods and services that they have at hand was high and if they are to sell those goods and services at all, they would have to lower their prices (Blanchard 1987, p.24). This coupled with a drop in marginal interests and a general increase in marginal costs affects their revenue and some of the firms’ begin running at a loss. Eventually with production cut backs and lay off of workers, the firms are left with no other alternative than to close.
Declining demand for goods and services
Declining firms’ profitability due to a decrease in revenue attributed from the drop in sales due to low demand for goods and services

            Unless the above trend is checked, with by such measures as increased spending by the government or cutting on interest rates, it could lead to a recession i.e. a general economic slowdown in all sectors of the economy.

Effect of rising demand on the number of firms and firms’ profitability
An increase in demand causes firms to produce more to meet the markets demand. Firms will try to employ more workers off course at a lower marginal cost and even though as per the aggregate demand curve, the prices are decreasing, the firms are enjoying large scale sales which eventually do bring in the, much needed revenues.
Therefore in the short run, there will be massive investment due to the low prices and the firms will produce more to counter this overspending habit and a general feeling that the same money they had had increased its value. With inability of only the existing firms to meet the market demand for goods and services, new market players will see the opportunity and seize the moment and also start production. Though the prices are a bit low, they are encouraged by the high demand (Duetsch, 1993, p.96).
In the long run, due to increasing demand, the prices will again begin to steadily rise since by now the rate of unemployment has reduced and thus the employees steadily demand more from their employers (Deustch, 1993). Since the firms do not want to incur the associated costs of employment and other marginal costs incurred, they would eventually pass down the expenses to the consumer. Despite this, the firms continually make profits from the demand and the number of firms will continue to be on the rise until there is a drop in the demand for the goods and services.

Increasing demand for goods and services   
. . . . . . . . . .


The two scenarios above give the impression that from one year to another, economic activities within the market usually fluctuates. However goods and services production increases in most years together with an increase in the overall number of firms due to increasing demand and a number of other factors. These other factors include labor force, technological advancement, and many other minor factors which eventually lead to improved economy.
            Unfortunately in some other years, there is a down-turn of economy when firms cannot successfully sell their goods and services thus leading to losses. To prevent further loss, they do cut on production as some people lose their jobs and when it becomes worse, firms close down.
            From the above assessment, it comes to a conclusion that a drop in demand for goods and services leads to drop in firm’s profitability in the short run. However in the long run, it will certainly lead to closing of some firms due to increased costs of production. Conversely, an increase in production leads to an increase in profitability of firms in the short run and a further increase in the number of firms operating in the long run due to increasing profits.

Krizanova A. & Martin H. (2006). The analysis of demand and price effect on firm’s revenue. EDIS ŽU Žilina 2(11) 212-234.
Epstein, R.L. et al. (2005). The Guide to Critical Thinking in Economics. South-Western: Thomson.
Duetsch, Larry L. (1993). Industry Studies. Englewood Cliffs, NJ: Prentice Hall.
Perloff, J. (2008). Microeconomic Theory & Applications with Calculus. Pearson.
Blanchard O.J & Kiyotaki N (1987) Monopolistic Competition and the effects of aggregate demand. The American Economic Review.77(4) 23-35

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