NCERT Class 12 Economics The Theory of the Firm under Perfect Competition

In the previous chapter, we studied concepts related to a firm’s production function and cost curves. The focus of this chapter is different. Here we ask : how does a firm decide how much to produce? Our answer to this question is by no means simple or ncontroversial. We base our answer on a critical, if somewhat unreasonable, assumption about firm behaviour – a firm, we maintain, is a ruthless profit maximiser. So, the amount that a
firm produces and sells in the market is that which maximises its profit.
The structure of this chapter is as follows. We first set up and examine in detail the profit maximisation problem of a firm. This  done, we derive a firm’s supply curve. The supply curve shows the levels of output that a firm chooses to produce for different values of the market price. Finally, we study how to aggregate the supply curves of individual firms and obtain the market supply curve.

PERFECT COMPETITION: DEFINING FEATURES

In order to analyse a firm’s profit maximisation problem, we must first specify the market environment in which the firm functions. In this chapter, we study a market environment called perfect competition. A perfectly competitive market has two defining features 1. The market consists of buyers and sellers (that is, firms). All firms in the market produce a certain homogeneous (that is, undifferentiated) good. 2. Each buyer and seller in the market is a price-taker. Since the first feature of a perfectly competitive market is easy to understand, we focus on the second feature. From the viewpoint of a firm, what does price-taking entail? A price-taking
firm believes that should it set a price above the market price, it will be unable to sell any quantity of the good that it produces. On the other hand, should the set price be less than or equal to the market price, the firm can sell as many units of the good as it wants to sell. From the viewpoint of a buyer, what does pricetaking entail? A buyer would obviously like to buy the good at the lowest possible price. However, a price-taking buyer believes
that should she ask for a price below the market price, no firm will be willing to sell to her. On the other hand, should the price asked be greater than or equal to the market price, the buyer can obtain as many units of the good as she desires to buy.
Since this chapter deals exclusively with firms, we probe no further into buyer behaviour. Instead, we identify conditions under which price-taking is a reasonable assumption for firms. Price-taking is often thought to be a
reasonable assumption when the market has many firms and buyers have perfect information about the price prevailing in the market. Why? Let us start with a situation wherein each firm in the market charges the same (market) price and sells some amount of the good. Suppose, now, that a certain firm raises its price above the market price. Observe that since all firms produce the same good and all buyers are aware of the market price, the firm in question loses all its buyers. Furthermore, as these buyers switch their purchases to other firms, no “adjustment” problems arise; their demands are readily accommodated when there are many firms in the market. Recall, now, that an individual firm’s inability to sell any amount of the good at a price exceeding the market price is precisely what the price-taking assumption stipulates.

Excercise

1. What are the characteristics of a perfectly competitive market?
2. How are the total revenue of a firm, market price, and the quantity sold by the firm related to each other?
3. What is the ‘price line’?
4. Why is the total revenue curve of a price-taking firm an upward-sloping straight line? Why does the curve pass through the origin?
5. What is the relation between market price and average revenue of a pricetaking firm?
6. What is the relation between market price and marginal revenue of a pricetaking firm?
7. What conditions must hold if a profit-maximising firm produces positive output in a competitive market?
8. Can there be a positive level of output that a profit-maximising firm produces in a competitive market at which market price is not equal to marginal cost? Give an explanation.

9. Will a profit-maximising firm in a competitive market ever produce a positive level of output in the range where the marginal cost is falling? Give an explanation.
10. Will a profit-maximising firm in a competitive market produce a positive level of output in the short run if the market price is less than the minimum of AVC? Give an explanation.
11. Will a profit-maximising firm in a competitive market produce a positive level of output in the long run if the market price is less than the minimum of AC? Give an explanation.
12. What is the supply curve of a firm in the short run?

13. What is the supply curve of a firm in the long run?

Please refer to attached file for NCERT Class 12 Economics The Theory of the Firm under Perfect Competition