Class 12 Economics Notes Chapter 4 (The theory of the firm under perfect competition) – Introduction MicroEconomics Book
Alright class, let's delve into Chapter 4: The Theory of the Firm under Perfect Competition. This is a foundational chapter for understanding how markets function, and concepts here are frequently tested in government exams. Pay close attention to the definitions, conditions, and relationships we discuss.
Chapter 4: The Theory of the Firm under Perfect Competition - Detailed Notes
1. Introduction to Perfect Competition
- Definition: Perfect competition describes a market structure characterized by a large number of buyers and sellers dealing in a homogeneous (identical) product, with perfect information and freedom of entry and exit for firms.
- Key Features:
- Large Number of Buyers and Sellers: No single buyer or seller can influence the market price. Each is a 'price taker'.
- Homogeneous Product: Products offered by all firms are identical in quality, size, shape, etc. This means buyers have no preference for one seller over another based on the product itself.
- Freedom of Entry and Exit: Firms can easily enter the industry if they see profit opportunities and exit if they incur losses, in the long run. There are no significant barriers (legal, technological, financial).
- Perfect Knowledge: Both buyers and sellers have complete information about market prices and product quality.
- Perfect Mobility of Factors of Production: Resources (labour, capital) can move freely between industries.
- No Selling Costs: Since products are homogeneous and information is perfect, firms don't need to incur advertising or sales promotion costs.
- No Transport Costs (often assumed): Or transport costs are uniform for all firms.
- Implication: The most crucial implication is that an individual firm under perfect competition is a price taker. It has to accept the price determined by the market forces of demand and supply. The firm's demand curve (and AR curve) is perfectly elastic (a horizontal line at the market price).
2. Revenue Concepts under Perfect Competition
Since a firm is a price taker, it can sell any quantity of output at the prevailing market price (P).
- Total Revenue (TR): The total money receipt from the sale of a given amount of output.
TR = Price (P) × Quantity (Q)- Since P is constant, TR increases at a constant rate as Q increases. The TR curve is a straight line starting from the origin, sloping upwards.
- Average Revenue (AR): Revenue per unit of output sold.
AR = TR / Q = (P × Q) / Q = P- Therefore, under perfect competition, AR is always equal to the market price (P). The AR curve is a horizontal straight line parallel to the X-axis at the level of the market price. This is also the firm's demand curve.
- Marginal Revenue (MR): The additional revenue generated from selling one more unit of output.
MR = Change in TR / Change in Q = ΔTR / ΔQ- Since the price (P) is constant, each additional unit sold adds exactly P to the total revenue.
- Therefore, under perfect competition, MR is also always equal to the market price (P).
- Key Relationship: Under Perfect Competition:
Price (P) = Average Revenue (AR) = Marginal Revenue (MR). The AR and MR curves coincide as a horizontal line.
3. Profit Maximization
A firm aims to maximize its profit (π), which is the difference between Total Revenue (TR) and Total Cost (TC).
π = TR - TC
A firm reaches equilibrium (maximizes profit) when the following conditions are met:
- Condition 1: Price (P) = Marginal Cost (MC) (or MR = MC, since P=MR)
- If P > MC, the firm can increase profit by producing more (revenue from the extra unit exceeds its cost).
- If P < MC, the firm can increase profit (reduce loss) by producing less (cost of the last unit exceeds the revenue it brings).
- Profit is maximized only when the revenue from the last unit (P) equals the cost of producing it (MC).
- Condition 2: Marginal Cost (MC) must be non-decreasing (i.e., rising or constant) at the equilibrium output level.
- This ensures that crossing the P=MC point actually leads to maximum profit, not minimum profit. If MC were falling, producing more beyond the P=MC point would lead to P > MC, indicating further profit potential.
- Condition 3 (Short-Run): Price (P) ≥ Average Variable Cost (AVC)
- In the short run, a firm must cover at least its variable costs to continue production. Fixed costs are sunk and must be paid regardless of output (even at zero output).
- If P > AVC, the firm covers all variable costs and contributes something towards fixed costs, minimizing losses compared to shutting down.
- If P = AVC, this is the Shutdown Point. The firm is indifferent between producing and shutting down, as its loss equals its total fixed costs in either case.
- If P < AVC, the firm cannot even cover its variable costs per unit. It minimizes losses by shutting down production immediately (loss will be limited to Total Fixed Costs).
- Condition 4 (Long-Run): Price (P) ≥ Average Cost (AC) (or Long-run Average Cost - LAC)
- In the long run, all costs are variable. A firm must cover all its costs (both fixed and variable components, now captured in LAC) to remain in the industry.
- If P < LAC, the firm incurs losses and will exit the industry.
- If P = LAC, the firm earns Normal Profit (zero economic profit) and stays in the industry. This is the long-run equilibrium condition for the industry.
- If P > LAC, the firm earns Supernormal Profit, which attracts new firms into the industry in the long run, eventually driving the price down to P = minimum LAC.
4. The Supply Curve of a Firm
The supply curve shows the relationship between the price of a good and the quantity the firm is willing and able to offer for sale. It's derived from the profit maximization conditions.
- Short-Run Supply Curve: It is the rising portion of the Short-run Marginal Cost (SMC) curve from and above the minimum point of the Average Variable Cost (AVC) curve.
- Why? Because a firm produces only where P = MC (Condition 1), MC is rising (Condition 2), and P ≥ AVC (Condition 3). Below the minimum AVC, the firm shuts down (quantity supplied is zero).
- Long-Run Supply Curve: It is the rising portion of the Long-run Marginal Cost (LMC) curve from and above the minimum point of the Long-run Average Cost (LAC) curve.
- Why? Because in the long run, a firm produces where P = LMC (Condition 1), LMC is rising (Condition 2), and P ≥ LAC (Condition 4). Below the minimum LAC, the firm exits the industry (quantity supplied is zero).
5. Determinants of a Firm's Supply Curve
Factors that cause a shift in the supply curve (change in supply):
- Technological Progress: Improvements in technology typically reduce the cost of production (shifting MC and AC curves downwards/rightwards). This leads to firms being willing to supply more at each price, shifting the supply curve to the right.
- Input Prices: An increase in the price of inputs (like labour wages, raw materials) increases the cost of production (shifting MC and AC curves upwards/leftwards). Firms will supply less at each price, shifting the supply curve to the left. A decrease in input prices shifts the supply curve to the right.
- Unit Tax: Imposing a unit tax (tax per unit of output) increases the marginal cost. This shifts the MC curve upwards/leftwards, causing the supply curve to shift to the left.
6. Market Supply Curve
- Definition: The market supply curve shows the total quantity of a good that all firms in the market are willing to supply at different possible prices.
- Derivation: It is obtained by the horizontal summation of the individual supply curves of all firms in the market. At each price, add up the quantities supplied by each individual firm.
- The market supply curve is also upward sloping, reflecting the positive relationship between price and quantity supplied.
7. Price Elasticity of Supply (Es)
- Definition: Measures the responsiveness of the quantity supplied of a good to a change in its price.
- Formula:
Es = (Percentage Change in Quantity Supplied) / (Percentage Change in Price)
Es = (ΔQ / Q) / (ΔP / P) = (ΔQ / ΔP) × (P / Q)
Where: ΔQ = Change in quantity supplied, ΔP = Change in price, P = Initial price, Q = Initial quantity supplied. - Interpretation:
- Es > 1: Supply is Elastic (Quantity supplied changes proportionately more than price)
- Es < 1: Supply is Inelastic (Quantity supplied changes proportionately less than price)
- Es = 1: Supply is Unitary Elastic (Quantity supplied changes proportionately same as price)
- Es = 0: Supply is Perfectly Inelastic (Quantity supplied doesn't change regardless of price - vertical supply curve)
- Es = ∞: Supply is Perfectly Elastic (Suppliers are willing to supply any amount at a given price, but none below it - horizontal supply curve)
- Geometric Method: For a linear supply curve, elasticity can be measured by extending the supply curve to intersect the price (Y) or quantity (X) axis.
- If the supply curve intersects the Y-axis (positive price intercept), Es > 1 (Elastic).
- If the supply curve passes through the origin, Es = 1 (Unitary Elastic).
- If the supply curve intersects the X-axis (positive quantity intercept), Es < 1 (Inelastic).
Multiple Choice Questions (MCQs)
-
Which of the following is NOT a characteristic of a perfectly competitive market?
a) Large number of buyers and sellers
b) Homogeneous product
c) Significant barriers to entry
d) Perfect knowledge -
Under perfect competition, the demand curve for an individual firm is:
a) Downward sloping
b) Upward sloping
c) Perfectly elastic (horizontal)
d) Perfectly inelastic (vertical) -
For a firm in perfect competition, the condition Price = AR = MR holds true because:
a) The firm has significant market power.
b) The product has many substitutes.
c) The firm is a price taker and faces a constant price.
d) There are significant selling costs. -
A perfectly competitive firm maximizes profit in the short run when:
a) TR = TC
b) P = MC and MC is rising
c) P = AVC
d) AR = AC -
The 'shutdown point' for a firm in the short run occurs when the price falls below the minimum of:
a) Average Total Cost (ATC)
b) Marginal Cost (MC)
c) Average Variable Cost (AVC)
d) Average Fixed Cost (AFC) -
The short-run supply curve of a perfectly competitive firm is represented by:
a) The entire Marginal Cost (MC) curve.
b) The rising portion of the Average Variable Cost (AVC) curve.
c) The rising portion of the MC curve above the minimum AVC.
d) The rising portion of the MC curve above the minimum ATC. -
In the long run, a firm will exit a perfectly competitive industry if:
a) Price is greater than Long-run Average Cost (LAC).
b) Price is equal to Long-run Average Cost (LAC).
c) Price is less than Long-run Average Cost (LAC).
d) Price is equal to Long-run Marginal Cost (LMC). -
If technological progress occurs in a perfectly competitive industry, the firm's supply curve will likely:
a) Shift to the left
b) Shift to the right
c) Remain unchanged
d) Become steeper -
The market supply curve under perfect competition is obtained by:
a) Vertically summing individual firms' supply curves.
b) Horizontally summing individual firms' supply curves.
c) Averaging individual firms' supply curves.
d) Finding the supply curve of the largest firm. -
If a linear supply curve passes through the origin, the price elasticity of supply is:
a) Greater than 1 (Elastic)
b) Less than 1 (Inelastic)
c) Equal to 1 (Unitary Elastic)
d) Equal to 0 (Perfectly Inelastic)
Answer Key for MCQs:
- c) Significant barriers to entry
- c) Perfectly elastic (horizontal)
- c) The firm is a price taker and faces a constant price.
- b) P = MC and MC is rising
- c) Average Variable Cost (AVC)
- c) The rising portion of the MC curve above the minimum AVC.
- c) Price is less than Long-run Average Cost (LAC).
- b) Shift to the right
- b) Horizontally summing individual firms' supply curves.
- c) Equal to 1 (Unitary Elastic)
Make sure you understand the reasoning behind each concept and condition, especially the profit maximization rules and the derivation of the supply curve. These are crucial areas for your exams. Let me know if any part needs further clarification!