Question

(Related to the Don't Let This Happen fo You on page 418 ) Explain whether you agree with the following remark: According to the model of perfectly competitive markets, the demand curve for wheat should be a horizontal line. But this can't be true: When the price of wheat rises, the quantity of wheat demanded falls, and when the price of wheat falls, the quantity of wheat demanded rises. Therefore, the demand curve for wheat is not a horizontal line.

Short answer

The statement confuses the individual firm's demand curve in a perfectly competitive market (which is perfectly elastic i.e., horizontal at the market price as the firm is a price taker) with the overall market demand curve (which is negatively sloped). Both are different concepts and serve different purposes in economic analysis. The individual firm's demand curve being horizontal does not contradict with the overall market demand for wheat being negatively sloped.

Step-by-step solution

Understand the perfectly competitive market model

In a perfectly competitive market, all firms are price takers and the market price is determined by the intersection point of the market supply and demand curve. An individual firm can sell all it can produce at this market price (price is given). Therefore, the demand curve for a firm in a perfectly competitive market is a horizontal line at the market price.

Distinguish between individual firm's demand and market demand

The important thing is to distinguish between the demand curve an individual firm faces in a perfectly competitive market (which is horizontal at the market price) and the market demand curve. The market demand curve is not a horizontal line. It is downwards sloping (negatively sloped), indicating that as the price of a good or service increases, the quantity demanded by the market decreases and vice versa.

Conclusion

So, as per the model of perfectly competitive markets, the demand curve for wheat from the perspective of an individual firm would be a horizontal line (price taker). However, the overall market demand for wheat, when looking at all consumers, is indeed not a horizontal line but a negatively sloped line, as the price and quantity demanded have an inverse relationship.

Key concepts

Market Demand Curve

Understanding the market demand curve is essential when studying economics, especially in the context of a perfectly competitive market model. The market demand curve graphically represents the relationship between the price of a product, like wheat, and the total quantity demanded by all consumers within the market.

The demand curve typically slopes downwards from left to right, illustrating the law of demand: as the price falls, the quantity demanded usually increases, and conversely, as the price rises, the quantity demanded tends to decrease. This inverse relationship is due to a combination of the substitution effect (consumers switch to cheaper substitutes as price increases) and the income effect (a higher price means effectively lower consumer income to spend on goods).

It's important to distinguish between the market demand curve and the demand curve for an individual firm in a perfectly competitive market, which is horizontal. The market demand curve accounts for the collective response of all consumers in the market to price changes and is crucial in determining market price alongside the market supply curve.

Price Takers

In perfectly competitive markets, firms are considered 'price takers.' This term means each firm has no control over the price of the product it sells; rather, the price is determined by the overall market conditions, specifically the intersection of supply and demand.

Characteristics of Price Takers

• No individual firm can influence the market price by altering its output or sales strategy.
• Firms must accept the prevailing market price and sell their goods at this price.
• The products sold are homogenous, meaning there are no distinguishing features between the products from different firms.

Being a price taker is a result of the individual firm's insignificance in the overall market size. In essence, the firm’s supply represents only a tiny fraction of the market supply, thus, the actions of one single firm have no noticeable impact on market price.

Supply and Demand Intersection

A central concept in economics is the intersection of the supply and demand curves, which determines the market equilibrium price and quantity. At this intersection, the quantity of goods that producers are willing to supply at a certain price is equal to the quantity that consumers are willing to buy.

This equilibrium point signifies a state of balance in the market. If the price were above this point, a surplus would occur, leading producers to lower their prices to clear their excess stock. Conversely, if the price were below equilibrium, a shortage would happen, prompting consumers to bid up the price to secure the limited supply.

In a perfectly competitive market, the equilibrium ensures that resources are allocated efficiently, as the price and quantity are set naturally by the collective actions of all buyers and sellers. Understanding the significance of the supply and demand intersection helps in grasping how market economies adjust to changes in production costs, consumer preferences, technology, and other external factors.