Question

We know that a profit maximizing competitive firm will set its price equal to the market price. Briefly describe why a profit maximizing competitive firm will not set its price above the market price. Also, describe why a profit maximizing competitive firm will not set its price below the market price.

Answer 1

The market price is determined by the market forces of demand and supply and it is accepted by all the individual firms. Suppose that an individual firm decides to charge a higher price. Since all other firms are selling identical goods, consumers are likely to purchase them from the seller with the least price. now this individual firm has set a higher price which means no consumable purchase from it. ultimately it has to reduce its price to bring it to the level of market price to make sales

Suppose that this individual firm decides to charge a lower price. There is no additional benefit of reducing its price because even at the market price it is able to sell as much quantity as it wants. it cannot increase its sales by lowering the price because it is already bound by its capacity at the market price. Due to this reason there is no incentive to reduce the price charged below the market price.

Hence individual firms take the market price as given.