The Theory of the Firm under Perfect Competition

Perfect competition is a market structure characterised by the following features: 1. Large number of buyers and sellers: There are so many buyers and sellers that no single one can influence the market price. Each seller supplies an insignificant fraction of total market supply. 2. Homogeneous product: All sellers sell identical (perfectly substitutable) products. There is no product differentiation — e.g., wheat, rice, standardised commodity markets. 3. Free entry and exit: Firms can freely enter the market if profits are positive and exit if losses are persistent. There are no barriers to entry or exit. 4. Perfect information: All buyers and sellers have complete knowledge of prices, quality, and market conditions. 5. Perfect mobility of factors: Factors of production (labour, capital) can move freely between industries without restriction. 6. No transportation costs: Goods are delivered at the same price everywhere. Why is a perfectly competitive firm a price taker? • Because there are a very large number of firms, each producing an identical product, the individual firm has no power over price. • If a firm raises its price above the market price, all buyers will switch to other sellers offering the same product at the market price — the firm loses all its customers. • If a firm lowers its price below the market price, it would be selling at a loss when it could sell all it wants at the market price. • Therefore, the firm accepts (takes) the market price as given. • The demand curve facing the individual firm is perfectly elastic (horizontal) at the market price — it can sell any quantity at that price but nothing above it. • As a result, for a price-taking firm: Price = Marginal Revenue = Average Revenue.

Profit Maximisation Condition: A firm maximises profit where Marginal Cost (MC) = Marginal Revenue (MR), provided: 1. MC = MR (necessary condition), AND 2. MC is rising at the point of intersection (sufficient condition, to ensure it is a maximum not a minimum). For a perfectly competitive firm, MR = Price (P), so the condition becomes: P = MC (and MC must be rising) Intuition: • If P > MC: Each additional unit sold adds more to revenue than to cost — the firm should produce more. • If P < MC: Each additional unit costs more than it earns — the firm should produce less. • At P = MC: No gain from changing output — profit is maximised. Short-run Equilibrium: • If P > ATC at the profit-maximising output: The firm earns supernormal (economic) profit. • If P = ATC: The firm earns normal profit (zero economic profit) — this is the break-even point. • If AVC < P < ATC: The firm makes a loss but continues to produce in the short run because it covers its variable costs and contributes to paying fixed costs. Shut-Down Condition: • The firm shuts down (produces zero output) if price falls below minimum Average Variable Cost (AVC). • Shut-down condition: P < minimum AVC. • Reason: If P < AVC, the firm cannot even cover its variable costs. By shutting down, it only loses its fixed costs — which is better than the larger loss from operating. • If P = minimum AVC: The firm is at the shut-down point — indifferent between producing and shutting down. • The portion of the MC curve above minimum AVC is the firm's short-run supply curve.

Long-run Equilibrium: In the long run, under perfect competition, firms can enter or exit the industry freely. This process drives economic profit to zero. Process: If existing firms are making supernormal profits (P > LRAC): • New firms are attracted into the industry (free entry). • Industry supply increases → market price falls. • The price continues to fall until economic profits are eliminated. • In equilibrium: P = LRAC (minimum), so economic profit = 0. If existing firms are making losses (P < LRAC): • Firms exit the industry (free exit). • Industry supply decreases → market price rises. • The price continues to rise until losses are eliminated. • In equilibrium: P = LRAC (minimum), so economic profit = 0. Long-run equilibrium conditions: • P = MR = MC = minimum LRAC • At this point: P = SMC = SAC = LMC = LAC (minimum) Why only normal profit? • Normal profit is the minimum return required to keep a firm in the industry — it is the opportunity cost of entrepreneurship, already included in the cost curves. • Economic profit (supernormal profit) = Total Revenue − Total Economic Cost (including normal profit). • Free entry and exit ensures any economic profit attracts new entrants and any economic loss causes exits — the process continues until economic profit = 0. • Therefore, in long-run equilibrium, firms earn only normal profit. Efficiency properties of long-run equilibrium: 1. Productive efficiency: Production occurs at minimum LRAC — firms produce at the lowest possible cost. 2. Allocative efficiency: P = MC — price reflects the marginal social cost of production, so resources are optimally allocated.