Chapter 4. Theory of Firm Under Perfect Competition

Perfect Competition: Defining Features
• concept of market refers to all such systems or arrangements that brings buyers and sellers in contact with each other to settle sale and purchase of goods.
• In economic theory, perfect competition occurs when all companies sell identical products, market share does not influence price, companies are able to enter or exit without a barrier, buyers have perfect or full information, and companies cannot determine prices.
• Features of Perfectly Competitive Market: A perfectly competitive market has following defining features:
(1) market consists of a large number of buyers and sellers, (2) Each firm produces and sells a homogeneous product, i.e., product of one firm cannot be differentiated from product of any other firm, (3) Entry into market as well as exit from market are free for firms, and
(4) Information is perfect.
• These features result in single-most distinguishing characteristic of perfect competition: price taking behaviour.

• revenue of a firm is its sale receipts or money receipts from sale of a product.
• Total Revenue: Total revenue [TR] of firm is defined as market price of good [p] multiplied by firm’s output [q]. Hence, TR = p × q TR = p × q’ is that of a straight line because p is constant. This means that TR curve is an upward rising straight line.
• Total Revenue curve: total revenue curve of a firm shows relationship between total revenue that firm earns and output level of firm. slope of curve, Aq Oq is market price.
• Average Revenue [AR]: average revenue [AR] of a firm is defined as total revenue per unit of output. Recall that if a firm’s output is q and market price is p, then TR equals p × q. price line shows relationship between market price and a firm’s output level. vertical height of price line is equal to market price, p.
• Marginal Revenue [MR]: marginal revenue [MR] of a firm is defined as increase in total revenue for a unit increase in firm’s output.

Profit Maximisation
• Profits are difference between total revenue and total cost. Both total revenue and total cost increases as output increases. Price/Marginal cost
Price/cost Price/cost
• A firm produces and sells a certain amount of a good. firm’s profit, denoted by p, is defined to be difference between its total revenue [TR] and its total cost of production [TC]. In other words p = TR – TC For profits to be maximum, three conditions must hold at q0:
• price, p, must equal MC. As long as marginal revenue is greater than marginal cost, profits are increasing.
• Marginal cost must be non-decreasing at q0.
• For firm to continue to produce,
(1) In short run, price must be greater than average variable cost [p > AVC];
(2) In long run, price must be greater than average cost [p > AC].

Supply Curve of a Firm
• A firm’s ‘supply’ is quantity that it chooses to sell at a given price, given technology, and given prices of factors of production.
• supply curve of a firm shows levels of output that firm chooses to produce corresponding to different values of market price.

Supply Schedule
• A supply schedule is a table that shows amounts sold by a company at various prices while keeping technology and factor prices constant.

Shut Down Point
• Along supply curve as we move down, last price-output combination at which firm produces positive output is point of minimum AVC, where SMC curve cuts AVC curve.
• Below this, there will be no production. This point is known as short run shut down point of firm. In long run, however, shutdown point is minimum of LRAC curve.

Normal Profit and Break-even Point:
• minimum level of profit that is needed to keep a firm in existing business is defined as normal profit.
• Profit that a firm earns over and above normal profit is known as super-normal profit.
• point on supply curve at which a firm earns only normal profit is known as break-even point of firm.

Determinants of a Firm’s Supply Curve
• Any factor that affects a firm’s marginal cost curve is of course a determinant of its supply curve.
• Technological Progress
• Input Prices

Note: If price of an input [say, wage rate of labour] increases, cost of production rises. consequent increase in firm’s average cost at any level of output is generally accompanied by an increase in firm’s marginal cost at any level of output; that is, there is a leftward [or upward] shift of MC curve. This means that firm’s supply curve shifts to left at any given market price, firm now supplies fewer units of output.

Market Supply Curve
• market supply curve shows output levels [plotted on x-axis] that firms in market produce in aggregate corresponding to different values of market price [plotted on y-axis].

Price Elasticity of Supply
• price elasticity of supply of a good measures responsiveness of quantity supplied to changes in price of good. More specifically, price elasticity of supply, denoted by eS. Price elasticity of supply, eS = Percentage change in quantity plied Percentage change in sup price
• price elasticity of demand and price elasticity of supply are independent of units.

• When supply curve is vertical, supply is completely insensitive to price and elasticity of supply is zero.
• When supply curve is positively sloped, with a rise in price, supply rises and hence, elasticity of supply is positive.

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