CHAPTER-4

THE THEORY OF FIRM UNDER PERFECT COMPETITION

I Choose the correct answer (1 mark)

1. In a perfect competition each firm produces and sells

a) Heterogeneous products c) Luxury goods
b) Homogeneous products d) Necessary goods

Homogeneous products

2. The increase in total revenue for a unit increase in the output is

a) Marginal Revenue c) Total Revenue
b) Average Revenue d) Fixed Revenue

Marginal Revenue

3. The firm’s profit is denoted by

a) ∑ b) Δ c) Φ d) π
π
4. When the supply curve is vertical, the elasticity of supply is
a) es=1 b) es>1 c) es=0 d) ex=∞
es=0
5. The revenue per unit of output of a firm is called as
a) TR b) MR c) AR d) None of these.

AR

II Fill in the blanks (1mark)

1. Price taking behavior is the single most distinguishing characteristic of ………………market-
Perfect competitive market.
2. …………….is a tax that the Government imposes per unit sale of output.
Unit Tax
3. For a price taking firm Marginal Revenue is equal to…………… Market price
4. The point of minimum AVC where the SMC curve cuts the AVC curves is called as
…………………… Shut down point
5. …………………cost of some activity is the gain forgone from the second-best activity.
Opportunity cost

1
 2

III Match the following

A B

1. MR= a) Perfect information

2. π= b) Zero profit
3. AR= c) ∆TR/∆Q
4. Normal profit d) TR-TC
5. Perfect competition e) TR/Q

Ans: 1 – (c); 2 – (d); 3 – (e); 4 – (b); 5 – (a)

Answer the following questions in a sentence or a word (1 Mark questions)

1. Define Marginal Revenue.

Marginal Revenue of a firm is defined as the increase(change) in Total Revenue for a unit
increase in the firm’s output. OR
It is the change in Total Revenue which results from the sale of one more unit of the good.
MR=∆TR/∆Q or MR=TRn-TRn-1.
2. To which side does a supply curve shift due to the technological progress?
The supply curve shifts to the RIGHT due to the progress in technology.
3. Write the formula to calculate Average Revenue.
We calculate Average Revenue, by dividing Total Revenue by the Quantity sold. The
following formula used:
AR = TR/q
4. What is normal profit?
The minimum level of profit that is needed to keep a firm in the existing business is called
as normal profit. A firm will be earning normal profit if its revenue is sufficient to cover
all its cost. It is a situation of Zero profit. π=TR=TC
5. Give the meaning of super normal profit.
Profit that a firm earns over and above the normal profit is called as super normal profit.
π= TR = TC where TR>TC
6. What does market supply curve show?
The market supply curve shows the output levels that firms in the market produce in
aggregate corresponding to different values of the market price. A market supply curve
is the summation of individual firm supply curve.
 7. What is a unit tax?
A unit tax is a tax that the government imposes per unit sale of output. E.g.: If
government imposes rs.2 as unit tax, the firm produces and sells 10 units of the good then
the total tax =Rs.20.

IV Answer the following questions in four sentences (2 marks)

1. Mention the conditions needed for profit by a firm under perfect competition.
The following conditions needed for profit by a firm under perfect competition:
• The Price (P) must be equal to Marginal Cost (MC) - (P=MC/MC=MR)
• Marginal cost must be non-decreasing at q0 (MC should be upward sloping at the point
of intersection)
• For a firm to continue production, in the short run, price must be greater than the
average variable cost(P>AVC) and in the long run, price must be greater than the
average cost(P>AC).

2. Give the meaning of shut down point.

A firm continues to produce as long as the price is greater than or equal to the
minimum of AVC in the short run and minimum of AC in the long run. In the short run,
shutdown point is that point of minimum Average Variable Cost Where Short Run Marginal
Cost curve cuts the Average Variable Cost curve. Below the minimum point of AVC there will be
no production. In the long run, the shutdown point is the minimum of Long Run Average Cost
Curve.

3. Write the meaning of opportunity cost with an example.

Opportunity cost is defined as the cost of next best alternative foregone or sacrificed
to produce a commodity.
For example, suppose you have Rs.10000 which you decide to invest in your family
business. If you do not invest this money in business, you can either keep it in the house
safe which will give you zero return or you can deposit in a bank which gives 10% rate of
interest. So, the maximum benefit that you may get from other alternative activities is the
interest from the bank. But this opportunity will no longer be there once you invest the
money in your family business. The opportunity cost of investing the money in your
family business is therefore the amount of forgone interest from the bank.
4. Mention the two determinants of a firm’s supply curve.
The two determinants of a firm’s supply curve are as follows:
(a) Technological progress
(b) Input prices.
(c) Impact of unit tax.
 5. Give the meaning of price elasticity of supply and write its formula.
The price elasticity of supply of a good measure the responsiveness of quantity supplied
to the changes in the price of the good. In other words, it is the measure of change in
quantity Supplied of a commodity due to change in the price.It is measured by using the
following formula.
PES or (es) = Percentage change in quantity supplied
Percentage change in price of the good

PES (es) = ∆Q x P
∆P Q
Where ∆Q is the change in quantity of the good supplied to the market, ∆P is the
change in price, Q is the initial quantity supplied and P is the initial price.

6. What is a unit tax?

A unit tax is a tax that the government imposes per unit sale of output. E.g.: If
government imposes rs.2 as unit tax, the firm produces and sells 10 units of the good then
the total tax =rs.20.

V Answer the following questions in 12 sentences

1. Write a short note on profit maximization of a firm under the following conditions
a) P=MC
b) MC must be none decreasing at q0 (MC curve must be upward sloping at the point of
intersection)
For profit maximization of any firm the difference between TR and TC must be maximum.
A firm always wishes to maximize its profit. The firm would like to identify the quantity q0,
the firm’s profits are less than at q0. For profits to be maximum, the following conditions
must hold at q0.
a) The price P must equal MC (P = MC): Profit is the difference between Total Revenue
and Total Cost. Both Total Revenue and Total Cost increase as output increases. If the
change in Total Revenue is greater than the change in Total Cost, profits will continue
to increase.
The change in Total Revenue per unit increase in output is the Marginal Revenue and
the change in Total Cost per unit increase in output is the Marginal Cost.
Therefore, we can conclude that if Marginal Revenue is greater than Marginal Cost
(MR>MC), profits are increasing and as long as Marginal Revenue is less than Marginal
Cost (MR<MC), profits will fall. It follows that for profits to be maximum, Marginal
Revenue should be equal to Marginal Cost (MR=MC).
For the perfectly competitive firm, we have established that the MR=P. So, the firm’s
profit maximizing output becomes the level of output at which P=MC.
 (CASE 1: MR>MC: Profits are increasing because there is possibility for a
firm to increase the profit by increasing the output. So, the firm increases the
production until P=MC.
CASE 2:MR<MC: When MR<MC the firm must increase the level of profit by cutting
down the production.) Optional
b) Marginal cost must be non-decreasing at q0: The second condition hold when profit
maximizing output level is positive. It means that the marginal cost curve cannot slope
downwards at the profit maximizing output level. This can be explained with the help
of diagram:
Y MC

P A B P=AR=MR

Price and

Marginal cost

O q1 q2 q3 q4 q5 q6 Output X

In the above diagram, at output levels q1 and q4 the Market Price is equal to the Marginal
Cost (Point A and B). However, at the output level q1 the marginal cost curve is downward
sloping. Therefore, q1 is not profit maximizing output level. At point B, output level q4
MC=MR and MC is rising. So, point B will be the profit maximizing output level (satisfies
both the condition).
If we observe all output levels left to the q1 the market price is lower than the Marginal
Cost. Between point A and B, revenue is more than cost which force the firm to expand
output until MC=MR. The output level after q4 , cost is more than revenue.

2. Explain the determinants of a firm’s supply curve.

A firm’s supply curve is a part of its marginal cost curve. Any factor that affects a firm’s
marginal cost curve is a determinant of its supply curve. Following are the factors determining a
firm’s supply curve:

a) Technological Progress:
The organizational innovation by the firm leads to more production of output. An
improvement in technology reduces the cost of production. It is expected that this will
lower the firm’s marginal cost at any level of output. Consequently, more of the
commodity will be supplied at existing price. As the firm’s supply curve is essentially a
 segment of the MC curve, technological progress shifts the supply curve of
the firm to the right. At any given market price, the firm now supplies more quantity of
output.
b) Input prices:
A change in the prices of factors of production (inputs) also influences a firm’s supply
curve. E.g.: If the price of input (e.g. wage) increases, the cost of production also increases.
The consequent increase in the firm’s average cost at any level of output is usually
accompanied by an increase in the firm’s marginal cost. That means, the firm’s supply
curve shifts to the left and the firm produces less quantity of output.
c) Tax policy of the government:
Government imposes taxes. When government increases taxes, the cost of production
increases and the supply curve shift to the left. If the government reduces taxes, then
supply curve may shift rightward and the firm may supply more units of output.
d) Goal of the firm:
If a firm’s goal is profit maximization, then the firm may supply more and try to maximize
profit. On the other hand, if a firm’s goal is risk minimization, then it may produce less and
supply less.
e) Number of firms: As the number of firms increases supply also increases and vice versa.
f) Nature of the market.
g) Expectations about future price:

3. Explain the features of perfect competition.

Perfect competition refers to a market situation in which there are large number of buyers and
sellers dealing with homogenous products at a uniform price.
i) large number of buyers and sellers: The existence of large number of buyers and sellers
means that each individual buyer and seller is very small compare to the size of the market. No
individual seller or buyer can influence the market price of the commodity by their size.

ii) Homogeneous products: Another prerequisite of perfect competition is that all the firms or
sellers must sell completely identical or homogeneous goods. Their products must be identical
in all aspects. There should not be any differentiation of products by sellers by way of quality,
colour, design, packing or other selling conditions of the product.

iii) Free Entry and Free exit for firms: Under perfect competition, any new firm is free to enter
the industry and any firm is free to leave the industry depending on their profit or loss.

iv) Price Taker: The single distinguishing character of perfect competition is the price taking
behaviour of the firms. In perfect competition uniform price prevails. It is determined by the
market forces of demand and supply. Neither the buyer nor the seller can influence the price of
the commodity. No single firm can influence the price level. Each firm must accept the existing
market price as they have zero market power irrespective of their supply and
demand. A price taking firm believes that if it sets a price above the market price, it will be
unable to sell any quantity of the good that it produces (lose their customers). On the other
hand, if the firm set the price less than or equal to the market price, the firm can sell as many
units of the good as it wants sell. The firms in the perfect competitive market are price takers.
That means, the producers will continue to sell their goods and services in the price existing in
the market. Firms have no control over the price of the product.

v) Information is perfect: Price taking is often thought to be a reasonable assumption when the
market has many firms. Buyers and sellers are completely informed about the price, quantity,
and other relevant details about the product as well as market. They have perfect information
about the price prevailing in the market.

vi) In perfect competition the market demand curve is perfectly elastic, and it is a horizontal
straight line parallel to X axis.

4.Write about Shut down point, Normal profit, and Break-even point.

Shut down point: A firm continues to produce as long as the price is greater than or equal to
the minimum of AVC in the short run and minimum of AC in the long run. In the short run,
shutdown point is that point of minimum Average Variable Cost Where Short Run Marginal
Cost curve cuts the Average Variable Cost curve. Below the minimum point of AVC there will be
no production. In the long run, the shutdown point is the minimum of Long Run Average Cost
Curve.

Normal profit: The minimum level of profit that is needed to keep a firm in the existing business
is called as normal profit. A firm will be earning normal profit if its revenue is sufficient to cover
all its cost. It is a situation of Zero profit. π=TR=TC. Profit that a firm earns over and above the
normal profit is called as super normal profit. π=TR=TC where TR>TC. In the long run a firm does
not produce if it earns anything less than normal profit. In the short run it may produce even if
the profit is less than the normal profit.

Breakeven point: The point of minimum of average cost at which the supply curve cuts the LRAC
curve is the break-even point. The point on the supply curve at which a firm earns normal profit
(TR=TC) is the breakeven point of the firm.

VI Answer the following questions in 20 sentences.

1. Explain the Short Run Supply Curve of a firm with the help of a diagram.
Supply curve of a firm shows the levels of output that the firm chooses to produce
corresponding to different values of the market price by keeping technology and prices of
factors of production constant.
Short Run Supply Curve of a Firm:
Let us derive a firm’s short run supply curve.
The derivation of supply curve can be split into two parts viz.,
a) Firm’s profit maximizing output level when the market price is greater than or equal to
minimum Average Variable Cost and
b) Firm’s profit maximizing output level when the market price is less than the minimum
Average Variable Cost.
Case 1: Price or Average Revenue greater than or equal to the minimum AVC:
This can be explained with the help of the following diagram

Y
Price,
costs SMC

SAC
AVC
P1

P2

O q1 output X

(Refer the diagram in textbook – page number 59 in Microeconomics)

If the market price is P1, which exceeds the minimum of AVC, the firm starts out by equating
P1 with SMC on the rising part of the SMC curve which leads to the output level q1 . But the
AVC at q1 does not exceed the market price P1. Thus, when the market price is P1, the firm’s
output level in the short run is equal to q1.
Case -2: Price is less than minimum AVC:
If the market price is P2 which is less than the minimum AVC, at all positive output levels, AVC
exceeds P2. In other words, it cannot be the case that the firm supplies a positive output. So,
if the market price is P2, the firm produces zero output.
Combining both the cases, we can conclude that a firm’s short run supply curve is the rising
part of the Short Run Marginal curve from and above the minimum Average Variable Cost
together with zero output for all prices strictly less than the minimum AVC.
 This can be represented in the following diagram:

In the above diagram, the short run supply curve of a firm, which is based on its short run
marginal cost curve and average variable cost is represented by the curve which rises from
the minimum point of AVC curve. The bold line represents the short run supply curve.

2. Explain market supply curve with the help of a diagram.

The market supply curve shows the output levels that firms in the market produce in
aggregate corresponding to different values of the market price.

For example, there are firm 1, firm 2, firm3 in the market. Suppose the price is fixed at p.
Then the output produced by these firms in aggregate will be supply of firm 1 + supply of firm
2 + supply of firm 3. So, the market supply at price p is the summation of the supplies of
individual firms at that price.
The supply curve geometrically with two firms in the market i.e., firm 1 and firm 2 is given
below. The two firms have different cost structures. Firm 1 will not produce anything if the
market price is less than P1 while firm 2 will not produce anything if the market price is less
than P2. This can be represented in the diagram:
Firm 1 Firm 2
Y (a) (b) (c)
S1 S2 Sm
P3

P2
P1

O q1 O q2 O q m output X
 In the above diagram, output is measured in X axis and Price is measured in Y axis. The
diagram (a) is the supply curve of firm 1 (S1), diagram (b) is the supply curve of firm 2 (S2)
and the diagram (c) is the market supply curve (Sm). When the market price is below P1, both
the firms do not produce the goods. Hence the market supply will be zero. If the market price
is greater than or equal to P1, but less than P2, only firm 1 will produce the goods. In this
range, the market supply curve coincides with the supply curve of firm 1. If the market price
is greater than or equal P2, both firms will have positive output levels. If the price is P3, the
firm 1 will supply q1 units of output and firm 2 supplies q2 units of output. So, the market
supply at price P3 is qm, where qm = q1 + q2. The market supply curve Sm is obtained by taking
a horizontal summation of the supply curves of the two firms in the market S1 and S2.

3. Explain the long run supply curve of a firm with the help of a diagram
To derive the long supply curve of a firm we split the derivation into two parts. First, we
determine the firm’s profit-maximizing output level when the market price is greater than or
equal to the minimum Long run Average Cost.
Case 1: Price greater than or equal to minimum of LRAC:

Y
Price,
costs LRMC

LRAC
P1

P2

O q1 output X

In the above diagram, if the market price is p1, which exceeds the minimum LRAC, with
LRMC rising, q1 output is produced. LRAC at q1 does not exceed the market price p1. Hence,
when the market price is p1, the firm’s supply, in the long run become an output equal to q1.

Case 2: Price less than the minimum LRAC: If the market price is P2, which is less than the
minimum LRAC the firm will not produce. Here the firm will not produce positive output. The
market price P2 must be greater than or equal to the LRAC at the level of output. So, in the
above diagram, LRAC exceeds P2.
 By combining both the cases, we conclude that a firm’s long run supply curve
is the rising part of the LRMC curve from and above the minimum LRAC together with zero
output for all the prices less than the minimum of LRAC.
The following diagram shows the long run supply curve of the firm.

In the above diagram, the long run supply curve of a firm, which is based on its long run
marginal cost curve and long run average cost curve is represented by the bold line.

4. Explain the Total Revenue and Average Revenue (price line) of a firm under perfect
competition with the help of a diagrams.
A firm earns revenue by selling the good that it produces in the market. Total Revenue is the
total amount received by the seller or a firm from the sale of a given amount of the product.
Let the market price of a unit of the good be P. Let q be the quantity of the good produced
and sold. Then TR of the firm = P X Q.
TR curve is shown in the following diagram
A total revenue curve measures the output on the X axis and the revenue earned on Y
axis.
3 observations:
1. The TR curve passes through the origin because the total revenue of the firm is zero
when the output is zero.
2. The TR curve of a price taking firm is an upward sloping straight line.TR increases as
the number of units increases.
3. The slope of the straight line = price
Average Revenue: It refers to the revenue per unit of output sold. It is obtained by
dividing the total revenue by the number of units of output sold. The average revenue is
defined as total revenue per unit of output.
So, AR = TR/Q = P x Q = P
Q
where, AR is Average Revenue, TR is Total Revenue and Q is quantities sold. That means,
for a price taking firm, average revenue equals the market price.
Under perfect competition, the AR will be equal to the market price and MR.
This is because, in perfect competitive market, the seller sells his product at the same
price which is prevailing in the market. If the seller sells at low price, he incurs losses or if
he increases the price, he loses customers. This can be represented in diagram:
Y

price

P Price line

O Output X

In the above diagram, the average revenue for different values of firm’s output is shown
in Y and X axis respectively. Since the market price is fixed at P, we obtain a horizontal
straight line that cuts the Y axis at a height equal to P.
This horizontal straight line is called the price line. It is also firm’s AR curve under Perfect
competition. The AR curve of a firm is also the demand curve of the customers, because
the price paid by the consumer for each unit is the average revenue from the seller’s
point of view.
VII Assignment and project-oriented questions.

1. Compute the total revenue, marginal revenue and average revenue schedules from
the following table when market price of each unit of goods is Rs.10.
Quantity sold TR MR AR

Ans: Hint: For TR Multiply Price and Quantity (Px Q).

MR = TRn-TRn-1 and AR = TR/Q
Quantity sold TR MR AR

0 0 - -

1 10 10 10

2 20 10 10

3 30 10 10

4 40 10 10

5 50 10 10

6 60 10 10