CBSE Class 12 — Notes, Chapters & Practice Quizzes

Chapter 4: The Theory of the Firm under Perfect Competition

Summary

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 \(TR=p\times q\), and because price is fixed, average revenue and marginal revenue both equal price, \(AR=MR=p\); the demand curve facing the firm is a horizontal (perfectly elastic) price line. The firm is a profit maximiser, where profit \(\pi=TR-TC\). Profit is maximised at the output where three conditions hold: price equals marginal cost \(p=MC\), 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, \(e_s=\dfrac{\%\,\Delta Q}{\%\,\Delta P}\), measures how responsive supply is to price.

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