The Theory of the Firm under Perfect Competition — Class 12 Economics

A perfectly competitive market has many buyers and sellers, a homogeneous product, free entry and exit, and perfect information. Its key feature is price-taking behaviour: each firm is too small to influence the price and simply accepts the market price. For such a firm total revenue is , and because price is fixed, average revenue and marginal revenue both equal price, ; the demand curve facing the firm is a horizontal (perfectly elastic) price line. The firm is a profit maximiser, where profit . Profit is maximised at the output where three conditions hold: price equals marginal cost , marginal cost is non-decreasing, and price is at least the average variable cost in the short run (or average cost in the long run). From these conditions the firm’s supply curve is derived — it is the rising part of the marginal cost curve above the minimum AVC (short run) or minimum LRAC (long run), with zero output below that. The shut-down point is the minimum of AVC, and the break-even point is where the firm earns only normal profit at the minimum of average cost. Factors such as technological progress, input prices, a unit tax and the number of firms shift the supply curve. The market supply curve is the horizontal sum of individual firms’ supply curves, and the price elasticity of supply, , measures how responsive supply is to price.