Chapter 4: The Theory of Firm under Perfect Competition

A perfectly competitive market exhibits the following characteristics:

i) There are many sellers and buyers in every category.

ii) Multiple choices for similar products.

iii) Sellers or buyers are well-informed and are free to make decisions based on their knowledge of the market.

iv) All the products are homogeneous. Because every product has the same properties, a uniform price can be achieved.

v) There is no price control, and the producers can set the prices as per the market demands and supply chains available.

vi) There is no extra cost due to marketing or advertising.

vii) All companies have access to the market without any transport cost.

The total revenue of a firm is the sum of all revenue earned by the firm. The market price is the price under which the product is sold in the market. In an ideal scenario, the company can control the market price by determining the amount of output that gets sold. And thereby, the company dictates its own scale of revenue.

A price line or a budget line represents the various combinations and possible quantities of two goods that can be purchased with a given income and assumed prices.

For a price-taking firm, the Average Revenue (AR) is always constant. When AR is constant, Marginal Revenue (MR) is also constant. This means that the Total Revenue (TR) of the firm increases in the same proportion when the price is constant. Therefore, we see a TR curve that slopes upward as a straight line. When the output level is zero, the TR curve passes through the origin.

The average revenue of a price-taking firm is equal to its market price.

The marginal revenue of a price-taking firm is equal to its market price.

The following conditions must be satisfied if a profit-maximising firm produces positive output in a competitive market:

1. Marginal cost should be equal to that of marginal revenue. In other words, MC = MR at equilibrium output.

2. Marginal cost should rise above the marginal revenue after exceeding the equilibrium output level.

3. The price should be greater than or equal to the average variable cost at the equilibrium output level (AVC) in the short run

4. The price should be greater than or equal to the average cost at the equilibrium output level in the long run.

The market price and marginal cost should always be the same for a perfectly competitive firm. So, a positive level of output will not occur when the market price is not equal to the marginal cost.

No, this is not possible. In a perfectly competitive market, the marginal cost curve should keep rising. So, a profit-maximising firm cannot produce a positive level of output when the marginal cost is falling. For a positive level of output, the marginal cost should be rising.

A firm which has its objective of profit maximising under the condition of the market price being less than the minimum AVC (average variable cost) will be unable to produce a level of output in the short run because when the market price falls to the level of minimum AVC, it indicates that further production cannot be continued and in such a condition a firm is unable to operate.