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This may seem like a basic question but it has been really bothering me for a while. I understand what excess supply is, and my question is regarding the firms' response to it.

All economics texbooks state that when there is excess supply

"there will be a downward pressure for firms to lower prices to the new equilibrium point".

I think this statement is not always true. I don't understand why firms always receive pressure to lower prices when there is excess supply.

For instance, if price elasticity of demand (demand elasticity) for the market is inelastic, lowering prices to get to the new equilibrium may actually lower the total revenue for the firm compared to the original price(where there was excess supply). In this scenario, I believe frims can definitely choose to simply maintain their prices at the excess supply level and ignore the stock that results from it, because the Total Revenue is higher compared to when firms lower the price to get to the new equilibrium.

So the question I wish to ask is, when there is excess supply, why are prices always lowered to the new equilibrium point where the quantity of demand increases and the quantity of supply decreases?

Why is there always a 'downward pressure' when, depending on the elasticity of demand, maintaining the price at the excess supply level can result in higher Total Revenue for the firm compared to when the price is lowered to the new equilibrium?

Every economics textbook I searched states that firms will always lower prices when there is excess supply, but I really don't get it, especially learning later on about Total Revenue, elasticity of D, etc in the later chapters of Microeconomics. As stated at the beginning, no matter how much I put my thought into it I could not come up with an answer. I would sincerely appreciate it if someome could give me a clear answer on this. :D

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  • $\begingroup$ Have a think about what firms are trying to maximise. (hint: it's not total revenue) $\endgroup$ – EnergyNumbers Jul 25 at 6:45
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You are absolutely right. In many markets, especially consumer markets, which people often think of, firms are not forced to lower prices. If a bakery produces to much bread one day, it might make a bigger profit if it keeps the price and throws away the breads they have not sold at the end of the day. That is because its limited competition.

What many forget to tell you when they teach microeconomics, is which markets microeconomic models is designed to model. It is market with perfectly competition (infinitely many suppliers and consumers) and where everyone have perfect knowledge about prices. Think if big international markets of standard products, like crude oil, flower, rice and stocks.

If you are a farmer wanting to sell rice on an international exchange (normally you will just sell directly to a distributer), you are to small to affect the market. Your only option is ether to sell a tiny amount below the spot price (the last transaction), or choose not to sell at all (something you probably don't want to do). If there are more sellers than buyers, the price is pressed downwards. This downward price pressure will continue until prices are either so small that buyers want to buy more, or the price is so low that some producers don't want to sell anymore.

If you did not understand the last paragraph you should probably read up on how stock/commodity market auctions work.

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  • $\begingroup$ thank you for the answer. I just want to ask a follow-up question - I thought firms in perfectly competitive markets were price takers, meaning that they can’t change the price. So how is the farmer able to lower the price of rice? Doesn’t that go against the assumption of perfectly competitive markets? $\endgroup$ – Robin Jul 25 at 10:20
  • $\begingroup$ All participants will move the price a tiny bit. In markets with a lot of participants, the price move so little when one farmer wants to sell that it is essentially is nothing. But it is still important to recognize that the price moves a tiny bit, because it explains why the price is pressed down, when not just one, but lots of farmers want to sell (and far less consumers are willing to buy). $\endgroup$ – JonT Jul 26 at 19:26

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