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The Theory of the Firm under Perfect Competition

The Theory of the Firm under Perfect Competition

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Impact of Technological Progress and Input Prices
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Market Supply Curve
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Perfect Competition
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Price Elasticity of Supply
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Profit Maximization under Perfect Competition
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Revenue Concepts
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Shut Down and Break-even Points
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Supply Curve Derivation
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Unit Tax Impact on Supply
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Learning Objectives

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Learning Objectives

  • Understand the concept of profit maximization in a firm under perfect competition.
  • Identify the defining features of a perfectly competitive market.
  • Analyze the relationship between market price and average/marginal revenue for price-taking firms.
  • Explain the conditions for a profit-maximizing firm to produce positive output in both short run and long run.
  • Describe the firm's supply curve in the short run and long run.
  • Evaluate the effects of technological progress, input price changes, and unit taxes on a firm's supply curve.
  • Compute total revenue, marginal revenue, and average revenue from given data.
  • Calculate price elasticity of supply and interpret its significance.

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Revision Notes & Summary

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The Theory of the Firm under Perfect Competition

4.1 Perfect Competition: Defining Features

  • Large number of buyers and sellers: Each is small compared to the market size.
  • Homogenous product: Products from different firms are identical.
  • Free entry and exit: Firms can easily enter or leave the market.
  • Perfect information: All buyers and sellers are fully informed about prices and products.

4.2 Revenue

  • Total Revenue (TR): TR = Market Price (p) × Quantity Sold (q)
  • Average Revenue (AR): For price-taking firms, AR = Market Price.
  • Marginal Revenue (MR): For price-taking firms, MR = Market Price.

4.3 Profit Maximisation

  • Profit: Profit = Total Revenue - Total Cost
  • Conditions for profit maximisation in the short run:
    1. p = Short-run Marginal Cost (SMC)
    2. SMC is non-decreasing
    3. p ≥ Average Variable Cost (AVC)
  • Conditions for profit maximisation in the long run:
    1. p = Long-run Marginal Cost (LRMC)
    2. LRMC is non-decreasing
    3. p ≥ Long-run Average Cost (LRAC)

4.4 Supply Curves

  • Short-run Supply Curve: Rising part of SMC curve above minimum AVC.
  • Long-run Supply Curve: Rising part of LRMC curve above minimum LRAC.

4.5 Determinants of a Firm's Supply Curve

  • Technological Progress: Shifts supply curve to the right (lower costs).
  • Input Prices: Increase in input prices shifts supply curve to the left (higher costs).
  • Unit Tax: Imposes additional cost per unit, shifting supply curve to the left.

4.6 Price Elasticity of Supply

  • Definition: Price elasticity of supply (es) = Percentage change in quantity supplied / Percentage change in price.
  • Example: If price rises from Rs 10 to Rs 30, and quantity supplied increases from 200 to 1000, then:
    • Percentage change in quantity supplied = (1000 - 200) / 200 × 100 = 400%
    • Percentage change in price = (30 - 10) / 10 × 100 = 200%
    • Therefore, es = 400% / 200% = 2.

4.7 The Shut Down Point

  • Short Run Shut Down Point: Minimum AVC where SMC curve intersects AVC curve.
  • Long Run Shut Down Point: Minimum LRAC curve.

4.8 Normal Profit and Break-even Point

  • Normal Profit: Minimum profit needed to keep a firm in business, considered an opportunity cost.
  • Break-even Point: Point where a firm earns only normal profit, at minimum average cost.
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Practice Test – MCQs, True/False

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Multiple Choice Questions

A.

Price must be greater than average variable cost (AVC)

B.

Price must be greater than average cost (AC)

C.

Price must be less than average variable cost (AVC)

D.

Price must be equal to average cost (AC)
Correct Answer: A

Solution:

In the short run, a firm will continue production as long as the price is greater than or equal to the average variable cost (AVC).

Chapter Concept:

Shut Down and Break-even Points

A.

0.75

B.

1.25

C.

1.5

D.

2
Correct Answer: B

Solution:

Price elasticity of supply, es=ΔQ/QΔP/P=(180−100)/100(60−40)/40=1.25e_s = \frac{\Delta Q/Q}{\Delta P/P} = \frac{(180-100)/100}{(60-40)/40} = 1.25.

Chapter Concept:

Price Elasticity of Supply

A.

Continue to produce at a loss.

B.

Produce zero output and shut down temporarily.

C.

Increase production to lower costs.

D.

Seek to increase prices to cover costs.
Correct Answer: B

Solution:

If the market price is below the minimum AVC, the firm will not cover its variable costs and will shut down in the short run.

Chapter Concept:

Profit Maximization under Perfect Competition

A.

The firm should continue producing as long as price is greater than average cost (AC).

B.

The firm should shut down production.

C.

The firm should increase production to reduce costs.

D.

The firm should decrease production to increase revenue.
Correct Answer: B

Solution:

In the short run, if the market price is less than the average variable cost (AVC), the firm should shut down production because it cannot cover its variable costs.

Chapter Concept:

Revenue Concepts

A.

It shifts the supply curve to the right

B.

It shifts the supply curve to the left

C.

It makes the supply curve perfectly elastic

D.

It has no effect on the supply curve
Correct Answer: B

Solution:

The imposition of a unit tax increases the cost of production, shifting the firm's long run supply curve to the left.

Chapter Concept:

Perfect Competition

A.

Because the price is less than the average variable cost

B.

Because the price is greater than the average variable cost

C.

Because the price is equal to the average cost

D.

Because the price is greater than the average cost
Correct Answer: A

Solution:

A firm will shut down production in the short run if the price falls below the average variable cost, as it would not cover its variable costs.

Chapter Concept:

Shut Down and Break-even Points

A.

A small number of buyers and sellers

B.

Differentiated products

C.

Free entry and exit

D.

Imperfect information
Correct Answer: C

Solution:

A perfectly competitive market is characterized by free entry and exit for firms.

Chapter Concept:

Perfect Competition

A.

The firm's average cost curve

B.

The firm's marginal cost curve

C.

The firm's total cost curve

D.

The firm's average variable cost curve
Correct Answer: B

Solution:

The short run supply curve of a firm is based on the rising part of its marginal cost curve from and above the minimum average variable cost.

Chapter Concept:

Supply Curve Derivation

A.

The supply curve shifts to the right.

B.

The supply curve shifts to the left.

C.

The supply curve becomes perfectly elastic.

D.

The supply curve remains unchanged.
Correct Answer: B

Solution:

A unit tax increases the cost of production, shifting the supply curve to the left.

Chapter Concept:

Profit Maximization under Perfect Competition

A.

The supply curve shifts to the left

B.

The supply curve shifts to the right

C.

The supply curve becomes vertical

D.

The supply curve remains unchanged
Correct Answer: B

Solution:

Technological progress allows a firm to produce more output with the same input, shifting the supply curve to the right.

Chapter Concept:

Perfect Competition

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True or False

Correct Answer: True

Solution:

The short run supply curve of a firm is indeed the rising part of the short run marginal cost curve (SMC) from and above the minimum average variable cost (AVC), as described in the text.

Chapter Concept :

Supply Curve Derivation

Correct Answer: True

Solution:

The price elasticity of supply, denoted by ese_s, is indeed defined as the percentage change in quantity supplied divided by the percentage change in price, as stated in the excerpt.

Chapter Concept :

Price Elasticity of Supply

Correct Answer: False

Solution:

In the short run, a profit-maximizing firm will not produce if the market price is below the average variable cost (AVC). This is because the firm would incur losses greater than its fixed costs, making it more economical to shut down production.

Chapter Concept :

Profit Maximization under Perfect Competition

Correct Answer: True

Solution:

In a perfectly competitive market, the firm is a price-taker, meaning it can sell as many units as it wants at the market price. Therefore, the marginal revenue, which is the additional revenue from selling one more unit, is equal to the market price.

Chapter Concept :

Revenue Concepts

Correct Answer: False

Solution:

A profit-maximizing firm in a competitive market will not produce a positive level of output in the short run if the market price is less than the average variable cost (AVC). In such a scenario, the firm would incur losses greater than its fixed costs, and it would be better off shutting down production.

Chapter Concept :

Profit Maximization under Perfect Competition

Correct Answer: True

Solution:

In a perfectly competitive market, the presence of many buyers and sellers, homogenous products, and perfect information leads to price-taking behavior.

Chapter Concept :

Perfect Competition

Correct Answer: True

Solution:

In the short run, a firm will continue to produce as long as the price remains greater than or equal to the minimum of AVC. Below this point, the firm will cease production.

Chapter Concept :

Shut Down and Break-even Points

Correct Answer: True

Solution:

In the short run, a profit-maximizing firm will continue to produce as long as the market price is greater than or equal to the minimum AVC. If the price falls below this level, the firm will cease production to minimize losses.

Chapter Concept :

Shut Down and Break-even Points

Correct Answer: True

Solution:

The short run supply curve of a firm is the rising part of the short run marginal cost (SMC) curve from and above the minimum average variable cost (AVC), together with zero output for all prices strictly less than the minimum AVC.

Chapter Concept :

Supply Curve Derivation

Correct Answer: True

Solution:

In a perfectly competitive market, the profit-maximizing condition for a firm is when marginal revenue (MR) equals marginal cost (MC). This is because any deviation from this equality would either increase costs more than revenue or miss out on potential profits.

Chapter Concept :

Profit Maximization under Perfect Competition

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