Economics Chapter 2.4 – The Theory of The Firm Under Perfect Competition

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Chapter 2.4 – The Theory of The Firm Under Perfect Competition

Economics Chapter 2.4 – The Theory of The Firm Under Perfect Competition

4.1 Perfect Competition: Defining Features

  1. Characteristics of Perfect Competition:
    • Large Number of Buyers and Sellers: Each participant is small relative to the market size, meaning no single buyer or seller can influence the market price.
    • Homogeneous Product: All firms sell an identical product, so consumers don’t differentiate between sources.
    • Free Entry and Exit: Firms can freely enter or leave the market, promoting competition.
    • Perfect Information: All buyers and sellers have complete knowledge about product quality and pricing.
  2. Price-Taking Behavior:
    • Firms and buyers in a perfectly competitive market are “price-takers,” meaning they must accept the market price.
    • Example: If a firm tries to set a price above the market price, consumers will switch to other firms. Conversely, buyers cannot purchase below the market price as firms wouldn’t sell at a loss.

4.2 Revenue in Perfect Competition

  1. Total Revenue (TR):
    • Defined as the total income a firm earns from selling its product at the market price.
    • Formula: TR=p×q, where ppp is the market price, and qqq is the quantity sold.
  2. Average Revenue (AR):
    • Average Revenue is the revenue per unit of output.
    • Formula: AR = TR/q = p
    • Interpretation: In perfect competition, average revenue is equal to the market price, resulting in a horizontal AR curve.
  3. Marginal Revenue (MR):
    • Marginal Revenue is the change in total revenue from selling an additional unit of output.
    • Formula: MR = ΔTR/Δq = p
    • In perfect competition, MR=AR=p, meaning each additional unit sold adds the same revenue as the previous one.
  4. Revenue Curves:
    • Total Revenue Curve: An upward-sloping line since TR increases with output.
    • Average Revenue and Marginal Revenue Curves: Horizontal at the market price level, reflecting a perfectly elastic demand faced by the firm.

4.3 Profit Maximization

  1. Defining Profit:
    • Profit (π\piπ) is the difference between total revenue (TR) and total cost (TC): π=TR−TC.
    • Firms seek to maximize this profit by adjusting output levels.
  2. Conditions for Profit Maximization:
    • Condition 1: MR=MC:
      • Profit maximization occurs when marginal revenue equals marginal cost (MC).
      • Explanation: As long as MR>MC, increasing output raises profit. When MR<MC, profit decreases. So, maximum profit is at MR=MC.
    • Condition 2: Non-Decreasing Marginal Cost:
      • At the profit-maximizing level, MC must be non-decreasing, ensuring stability.
    • Condition 3:
      • In the short run: p≥AVC
      • In the long run: p≥AC
      • These conditions ensure the firm covers at least variable costs in the short run and total costs in the long run.
  3. Graphical Representation of Profit Maximization:
    • The intersection of the firm’s marginal cost (MC) curve with the market price line indicates the profit-maximizing output.

4.4 The Supply Curve of a Firm

  1. Definition:
    • A firm’s supply curve shows the quantities it is willing to sell at different prices, given current technology and input costs.
    • Components: The short-run supply curve includes the upward-sloping portion of the marginal cost (MC) curve above the minimum of average variable cost (AVC).
  2. Short-Run Supply Curve:
    • Case 1: If p≥AVC, the supply curve is the rising part of the MC curve.
    • Case 2: If p<AVC, the firm produces zero output, as it can’t cover variable costs.
    • Conclusion: The short-run supply curve combines the rising MC curve and zero output when price is below minimum AVC.
  3. Long-Run Supply Curve:
    • Case 1: If p≥AC, the supply curve is the rising part of the long-run marginal cost (LRMC) curve.
    • Case 2: If p<AC, the firm exits the market in the long run.
    • The long-run supply curve incorporates zero output below minimum average cost (AC) and follows the LRMC curve above it.
  4. Shut-Down Point:
    • Short Run: The price at which the firm covers minimum AVC is the shut-down point. Below this, the firm ceases production.
    • Long Run: The shut-down point aligns with minimum average cost (AC).
  5. Break-even Point:
    • A firm earns “normal profit” at the point where price equals minimum AC.
    • Normal Profit: The minimum return necessary for the firm to stay in business, included in total costs as an opportunity cost for entrepreneurship.

4.5 Determinants of a Firm’s Supply Curve

  1. Technological Progress:
    • Enhances production efficiency, lowering marginal and average costs and shifting the supply curve to the right.
  2. Input Prices:
    • Rising input prices (e.g., labor wages) increase production costs and shift the supply curve to the left.
  3. Unit Tax Impact:
    • Unit Tax: A tax imposed on each unit sold, increasing marginal and average costs by the tax amount.
    • Effect: Shifts the supply curve to the left, as the firm now incurs additional costs per unit.

4.6 Market Supply Curve

  1. Definition:
    • The market supply curve represents the total quantity supplied by all firms at different price levels.
  2. Deriving the Market Supply Curve:
    • Horizontal Summation: The market supply is obtained by adding individual firms’ supply quantities at each price level.
    • Example with Two Firms: If firm 1 and firm 2 supply certain quantities at price ppp, the market supply at ppp is the sum of these quantities.
  3. Impact of Firm Numbers:
    • An increase in the number of firms shifts the market supply curve to the right, reflecting higher total supply at each price level.

4.7 Price Elasticity of Supply

  1. Definition:
    • Price elasticity of supply (eSe_SeS​) measures the responsiveness of quantity supplied to price changes.
    • Formula:

eS = Percentage change in quantity supplied / Percentage change in price

  1. Example:
    • If the price of a product rises and supply increases proportionately, elasticity can be calculated to determine the responsiveness.
  2. Types of Elasticity:
    • Elastic Supply (e_S > 1): Supply is highly responsive to price changes.
    • Inelastic Supply (e_S < 1): Supply is less responsive to price changes.
    • Unitary Elastic Supply (e_S = 1): Proportional response in supply to price changes.
  3. Geometric Interpretation:
    • The slope of the supply curve at a given point helps determine elasticity. For instance, a vertical supply curve indicates zero elasticity.

4.8  Summary of Key Points

  1. Perfect Competition:
    • Firms are price-takers, with a horizontal demand curve at the market price.
  2. Revenue Calculations:
    • Total revenue (TR), average revenue (AR), and marginal revenue (MR) are crucial for determining profit maximization.
  3. Profit Maximization:
    • Conditions include MR=MC and ensuring price covers AVC in the short run or AC in the long run.
  4. Supply Curves:
    • Short-run supply follows the MC curve above AVC; long-run supply follows the LRMC curve above LRAC.
  5. Determinants of Supply Curve:
    • Technological progress, input prices, and unit taxes can shift the supply curve.
  6. Market Supply Curve:
    • The aggregate of individual firms’ supply at each price level.
  7. Price Elasticity of Supply:
    • Measures how quantity supplied responds to price changes.

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