The Theory of the Firm under Perfect Competition Question Answers: NCERT Class 12 Micro Economics

This type of market structure refers to the market that consists of a larger number of buyers and also a large number of sellers. No buyers and also a large number of sellers. No individual seller is able to influence the price of an existing product in the market. All sellers in a perfect competition produce homogenous outputs i.e. the outputs of all the sellers are similar to each other and the products are uniformly priced.

Features of perfectly competitive market
The main features of perfectly competitive market are:

1. A larger number of buyers and sellers
There exist a larger number of buyers and sellers in a perfectly competitive market. The number of sellers is so large that no individual firm owns the control over the market
price of a commodity. Due to the large number of sellers in the market there exists a perfect and free competition. A firm acts as a price taker while the price is determined
by the invisible hands of market i.e. by demand for and supply of goods. Thus we can conclude that under perfectly competitive market an individual firm is a price taker and
not a price maker.

2. Homogenous products
All the firms in a perfectly competitive market produce homogeneous products. This implies that the output of each firm is perfect substitute to others output in terms of
quantity quality colour size features etc. this indicates that the buyers are indifferent to the output of different firms. Due to the homogeneous nature of products existence of
uniform price is guaranteed.

3. Free exit and entry of firms
In the Long run these is free entry and exit of firms. However in the short run some fixed factors obstruct the free entry and exit of firms. This ensures that all the firms in
the long-run earn normal profit or zero economic profit that measures the opportunity cost of the firms either to continue production or to shut down. If there are abnormal
profits new firms will enter the market and if there are abnormal losses a few existing firms will exit the market.

4. Perfect knowledge among buyers and sellers
Both buyers and sellers are fully aware of the market conditions such as price of a product at different places. The sellers are also aware of the prices at which the buyers
are willing to buy the product. The implication of this feature is that if any individual firm is charging higher or lower price for a homogeneous product the buyers will shift their purchase to other firms or shift their purchase from the firm to other firms selling at lower price.

5. No transport costs
This features means that all the firms have equal access to the market. The goods are produced and sold locally. Therefore there is no cost of transporting the product from
one part of the market to other.

6. Perfect mobility of factors of production
There exists geographically and occupationally perfect mobility of factors of production. This implies that the factors of production can move from one place to other and can
move from one job to another.

7. No promotional and selling costs
There are no advertisements and promotional costs incurred by the firms. The selling costs under perfectly competitive market are zero.

Total revenue is defined as the total sales proceeds of a producer by selling corresponding level of output. In other words it is defined as price times the quantity of output sold.
Total revenue = Price Quantity of output sold
TR = P × Q
TR = PQ
In a perfectly competitive market the market price is given i.e. a firm acts as a price taker and cannot influence the price. Hence a particular firm can influence its TR by altering the quantity of output sold.

Price line is the graphical representation of the relationship between output and price with x- axis denoting the output and y- axis denoting price. For a perfectly competitive firm price line and demand curve are the same.

The total revenue curve for a firm in a perfectly competitive market is an upward sloping curve because the price or AR remains constant and MR is also equal to AR. Thus TR can only be influenced by altering the output sold as the price remains constant. The increase in TR is in the same proportion as the increase in the output sold. The curve passes through the origin which implies that no matter what the price level is if the output sold is zero TR will also be zero.

Average revenue is defined as the revenue per unit of the output sold. It is expressed as the ratio between total revenue and the output sold.
AR =
We know that
TR = P × Q
AR=
AR = P
Thus the market price and the average revenue are the same for a perfect competitive firm.

Marginal revenue is defined as the change in the total revenue that occurs due to the sale of one more unit of output. It is calculated as
MR_n= TR_n – TR_n-1
Where
MR_n = Marginal revenue due to nth unit of output
TR_n = Total revenue due to n units of output
TR_n-1 = Total revenue due to n units of output
TR_n-1 = Total revenue due to (n-1) units of output
Suppose that the market price is P
MR_n = TR_n - TR_n-1
= PQ_n – P (Q_{n – 1})
MR = PQ_n – PQ_n+P
MR = P
Thus for a perfect competitive firm marginal revenue is equal to the market price per unit of output.

The following three conditions must hold if a profit maximising firm produces positive level of output (say equilibrium output Q)in a competitive market.
1. MR must be equal to MC at Q*
2. MC should be upward sloping or rising at Q*
3. In short run – Price must be greater than or equal to AVC. i.e. P at Q*
    In long run – Price must be greater than or equal to LAC.

There cannot be any positive level of output that a firm producers at which price is not equal to MC. Let us evaluate the following two cases where price is not equal to MC.

Case A: If P MC
At output Oq1, price is Kq1 while the MC is Lq1. So Oq1 is not the profit maximising output. This is due to the fact that the firm can increase its profit level by expanding its output to Oq2.

Case B: If P
At output Oq3 price is Hq3 and MC is Gq3 . so Oq3 is not the profit maximising output . this is because the firm can increase its profit by reducing its output level to Oq2. Thus at profit maximising point price must be equal to MC and it cannot be greater or lesser than MC.

It is not possible for any perfect competitive firm to produce a positive level of output in a range where MC is falling. This is because according to one of the conditions of profit maximisation MC curve should be positive at the equilibrium level of output.

Let us take an example:
At point Z price equal to MC but MC is falling and is negatively sloped. For any level of output more than Oq0 the firm facing priceMC which implies that the profit can be maximised by increasing the output level further. Hence the point E is the equilibrium point where a profit maximising firm would operate and produce Oq1 units of output and its profit will be maximized.

It is not possible for a firm to produce for a firm to produce positive level of output in the short run if the price is less than the minimum of AVC. This is because as soon as the market price falls below the minimum of SAVC which implies that the firm is not able to cover its fixed as well as variable costs and thus it will stop production.
Let us understand this concept by taking an example.
At the point K price charged by the firm is on and output sold is 0q1 and the firm generates TR.
TR = P × Q
= OP × Oq1
= area (rectangle Oq1 LP)
And incurs the variable cost of TVC
TVC = SAVC × Quantity of output
= ON × Oq1
= area (rectangle Oq1KN)
Profit earned by the firm = TR – TC =TR – (TVC + TFC)
= TR – TVC – TFC
If the firm is not producing anything then at zero level of output the firms TR and VC will by zero.
However the firm has to bear TFC. Thus at zero level of output the profit earned by the firm is
Profit = π1 = TR – TVC – TFC
π1= TFC
Now if it produces Oq1 level of output then the profit earned will be
π2 = TR – TVC – TFC
= area (rectangle Oq1LP) – area (rectangle Oq1KN) – TFC
Or π2 = area (rectangle PLKN) – TFC

This implies that π1 is greater than π2. The firm incurs more loss if it produces Oq1 level of output than the loss associated with zero level of output. Thus the firm will stop production whenever P SAVC and therefore at profit maximising level of output the price must be greater than or equal to SAVC in the short run.

It is not possible for a firm to produce positive level of output in the long run if the market price falls short of the minimum of AC. This is because in the long run there is free entry and exit of firms and all firms earn normal profit. Therefore any firm making losses in long run will stop production.
Let us understand this concept through an example:
At oq1 level of output
Price charged by the firm = OP.
Revenue generated by the firm (TR) = P × Q
= OP × Oq1
= area (rectangle Oq1LP)
Cost of producing Oq1 level of output (TC)= LAC × Quantity of output
ON × Oq1
TC = area (rectangle Oq1KN)
Profit earned by the firm = TR-TC
= area (rectangle Oq1Lp)-area (rectangle Oq1KN)
= - area (rectangle NKLP )
Thus the loss incurred by the firm is equal to the area of the rectangle NKLP.

In the long run all firms earn zero economic profit and if any firm earns loss or negative profit then the firm will shut down its production thus if the firm earn loss i.e. if price is lesser than LAC at any level of output it will not be the profit maximising output level of the firm.

The short run supply curve of perfect competitive firm is the summation of the upward sloping portion of SMC (above the minimum point of SAVC) where price min SAVC and vertical portion of price axis when price min SAVC.

Stage 1
When the price is greater than or equal to minimum of SAVC i.e, P min SAVC.
At the market price OP the three following conditions for equilibrium are fulfilled:
1. MC = MR
2. MC is upward sloping
3. Price exceeds the minimum of SAVC
At this market price the firm is producing profit maximising output Oq1,
In this case the supply curve of the firm is regarded as the upward sloping part of SMC (above the minimum point of SAVC) i.e SS. When the price is greater than or equal to minimum of SAVC the supply curve is indicted by SS.

Stage 2
When the price is less than the minimum of SAVC
Let us suppose that the firm is facing price OP1 that is lesser than the minimum of SAVC. At this price the firm cannot continue production as it cannot even cover up its variable costs and thereby incurs losses which implies that the firm would produce nothing. Thus it will incur loss that will be equivalent to its fixed costs. It will be lesser compared to the losses associated with producing any positive output level thus the firm will not produce anything at this price and thereby the quantity supplied will be zero. The firms supply curve is indicated by the darkened vertical lines S1S1.

In the long run as there is no fixed cost the perfectly competitive firms supply will be the summation of the upward sloping portion of SMC above the minimum point of LAC (When price minimum LAC) and the vertical portion of the price axis (when price minimum of LAC) the long run supply curve of a perfect competitive firm is derived in two stages.

1. When price is equal to the minimum of LAC:

Let us suppose that the firm is facing market price OP that exceeds the minimum of LAC. MC is equal to MR (at point E) and MC is positively sloped at this point of intersection. Also the price is greater than the
minimum of LAC. Thus the firm is at long run equilibrium facing the price OP and producing Oq1 units of output. The supply curve is SS represented by the upward portion of LMC above the minimum of LAC.

2. When the price is less than the minimum of LAC:
Let us suppose that the market price faced by a firm is OP1 which is less than the minimum of LAC. at this price the firm would not produce any output because
producing any output will lead therefore the firm would not produce anything so the supply curve of the firm in the long run for the price less than the minimum of LAC is
given S1S1 and is represented by the darkened vertical part of the price axis.

Combining 1 st and 2 nd stages the firms long run supply curve under perfect competition is given by (S1S1 + SS).

The supply curve of a firm is a positive function of a state of technology. Thar is if the technology available to the firm appreciates more amount of output can be produced by the firm with the given levels of capital and labour. Due to such innovations or technological advancements the firm will experience lower cost of production which will lead to rightward downward shift to the MC curve. This will further lead to rightward shift of the firms supply curve. Thus due to the appreciation and advancement of production techniques the firm will produce more and more output that will be supply at a given market price.

A unit tax is the tax imposed on per unit of the output sold. Due to the imposition of unit tax, the cost of production per unit of output increases, which ultimately increases the marginal cost. Consequently, the LMC curve will shift leftward upward and as the supply curve is a portion of LMC, so the supply curve will also shift leftward upward. Let us understand the effect of imposition of unit tax through an example. Suppose that a firm is facing the price OP₁. LAC₁ and LMC₁ are the long run average cost curve and long run marginal cost curve respectively. Also assume that the government has imposed a unit tax of Rs k per unit of output produced. Now, this will rise the firm's LAC and LMC, as the firm needs to pay Rs k extra on each output produced. Consequently, LMC₁ and LAC₁ will shift leftward upwards to LMC_2n and LAC₂. The magnitude of shift is equal to Rs k. As the supply curve is a part of LMC, it will also shift leftward from S₁ to S₂ , due to the imposition of the tax. Consequently, the firm will now supply lesser units of output.

An increase in the price of an input increases the cost of production, which in turn increases the marginal cost of the firm. Consequently, the MC curve will shift upward to the left and the supply curve will also shift leftward upward. Therefore, an increasein the input price negatively affects the supply of the firm.

The market supply curve is a horizontal summation of all the supply curves of individual firms in the market. If the number of firms in a market increases, then the market supply curve will shift rightward as there will be more number of firms supplying more amount of output.

Price elasticity of supply (es ) is defined as the degree of the responsiveness of quantity supplied, to the change in the price of a good.
It is expressed as:
es =
=
=
Where,
∆Q = change in quantity supplied
∆P = change in price
P = initial price
Q = initial supply

Profit maximising output is where the difference between TR and TC is the maximum. This exists at 5 units of output, where firm is earning profit of Rs 12.

At price P1 = Rs 10
TR1 = P1 × Q1 = 50
Total revenue,
=
=
= Q1 = 5 units
At price, P2 = Rs 15
Total revenue, TR2 = P2 × Q2 = 150
= Q2 =
= Q2 =

= Q2 = 10 units
es =
Elasticity of supply,
∆Q = Q2 – Q1 = 10 – 5 =5
P = P1 – P2 = 15 – 10 = 5
es =
es = 2

Elasticity of supply ex = 0.5
Initial price, P1 = Rs 5
Final price, P2 =Rs 20
∆P = P2 – P1
= 20 – 5
∆P = 15
∆Q = 15
es =
0.5 =
0.5 =
Q1 =
Initial quantity = 10 units
Final quantity, Q2 = ∆Q + Q1
= 15 + 10
Therefore, Q2 = 25 units

Initial price, P1 = Rs 10

Initial output, Q1 = 4 units
Final price, P2 = Rs 30
∆P = P2 – P1
= Rs 30 – 10 = Rs 20

Elasticity of supply es = 1.25
es =
1.25 =
= 1.25 × 8 = ∆Q
= ∆Q = 10 units

Thus final output supplied, Q2 = ∆Q + Q1
Q2 = 10 + 4 = 14 units