Chapter 4 — The Theory of the Firm Under Perfect Competition

A perfectly competitive market has four features: (1) a large number of buyers and sellers, (2) homogeneous products (identical across all firms), (3) free entry and exit, and (4) perfect information about price, quality, and other relevant details.

A price-taking firm believes that setting a price above the market price will result in zero sales, while at or below the market price it can sell as many units as it wants. Because all firms produce identical goods and buyers are fully informed, any firm charging above the market price immediately loses all its customers.

Total revenue (TR) = market price (p) × quantity sold (q). The TR curve is an upward-sloping straight line passing through the origin; its slope equals the market price.

The price line is a horizontal straight line drawn at the level of the market price on a price-output graph. It represents both the average revenue curve and the demand curve facing the firm under perfect competition, reflecting the fact that the firm can sell any quantity at the market price.

AR = TR/q = (p × q)/q = p. MR = change in TR per unit increase in output = [p(q2 − q1)]/(q2 − q1) = p. Every additional unit is sold at the market price, so both average and marginal revenue equal that price.

For a positive profit-maximising output in the short run: (i) P = SMC, (ii) SMC must be non-decreasing at that output level, and (iii) price must be greater than or equal to AVC. If any condition fails, the firm either shifts its output or shuts down.

For a positive profit-maximising output in the long run: (i) P = LRMC, (ii) LRMC must be non-decreasing at that output level, and (iii) price must be greater than or equal to LRAC. If price is below minimum LRAC, the firm produces zero output and exits.

The short run supply curve is the rising part of the SMC curve from and above the minimum AVC, together with zero output for all prices strictly below the minimum AVC. The point of minimum AVC (where SMC cuts AVC) is called the short run shut-down point.

The long run supply curve is the rising part of the LRMC curve from and above the minimum LRAC, together with zero output for all prices below the minimum LRAC. The long run shut-down point is the minimum of the LRAC curve.

Normal profit is the minimum level of profit needed to keep a firm in business; it is treated as part of the firm's total cost (an opportunity cost for entrepreneurship). Profit earned above normal profit is called super-normal profit. The break-even point is the point on the supply curve where the firm earns only normal profit — the minimum of the AC curve where the supply curve cuts it.

Technological progress allows the firm to produce the same output with fewer inputs, lowering marginal cost at every output level. This shifts the MC curve (and therefore the supply curve) to the right: at any given market price, the firm now supplies more units of output.

A unit tax of Rs t raises both long run marginal cost and long run average cost by Rs t at every output level. This shifts the long run supply curve to the left: at any given market price, the firm supplies fewer units of output.

The market supply curve is derived by horizontal summation of the supply curves of all individual firms. At any given price, market supply equals the sum of outputs supplied by each firm at that price. If the number of firms in the market increases, the market supply curve shifts to the right; if it decreases, the curve shifts to the left.

Price elasticity of supply (eS) = (percentage change in quantity supplied) ÷ (percentage change in price) = (ΔQ/Q) / (ΔP/P). It is unit-independent. A vertical supply curve has eS = 0; a supply curve passing through the origin has eS = 1; a supply curve cutting the price axis has eS > 1; a supply curve cutting the quantity axis at a positive value has eS < 1.

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