Explain why the price in competitive market settle down in the equllibrium intersaction of demand and supply?
Answer:
Well why not? Think what would happen if the price would be higher than the equilibrium. If you drew it out on a graph you would see that the Quantity Supplied is larger than the Quantity Demanded because the price is high. The suppliers want to supply more at that price but the buyer don't buy at such a high price. There will be a surplus of goods.
If the price is set lower than equilibrium then would see that the Quantity Demanded is higher than the Quantity Supplied. The price is low so buyer want to buy more while at the low price suppliers don't want to supply at that level. There will be a shortage of goods.
Naturally when one of the two cases happens the price will fall or rise back to equilibrium unless it affected by government law or collusion.
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Price settles down in equilibrium because of incentive. In other words, if I am a supplier, I compute the price elasticity of demand which is:
Ed = % Change in Quantity Demanded / % Change in Price.
If the result is less than 1, then I can raise price to the point where Ed = 1 and increase revenue. The reason this is so, is because the % of volume loss will be less than the % of the price increase (p * v = r, where p=price, v=volume, r=revenue).
If the result is greater than 1, then I can lower price to the point where Ed = 1 and also increase revenue. The reason this is so, is because the % volume gained will be greater than the % of the price decrease.
If Ed = 1, or empirically, is very close to 1, then I have no incentive to increase or decrease price, since any change in price will result in a like negative volume change. i.e. if I increase price by 5%, then I lose 5% in volume, so revenue is constant; If I lower price by 5%, then I only gain 5% in volume, so revenue is again constant.
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