NCERT Class 12 Economics Chapter 4: The Theory of the Firm under Perfect Competition YouTube Lecture Handouts

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Previous Chapters

  • Profit maximization
  • Supply Curve and market supply curve

Perfect Competition Features

  • The market consists of a large number of buyers and sellers (No individual buyer and seller can influence market size)
  • Each firm produces and sells a homogenous product. i.e.. , the product of one firm cannot be differentiated from the product of any other firm (buy from any firm)
  • Entry into the market as well as exit from the market are free for firms (important for large number of firms to exist)
  • Information is perfect (all buyers and sellers are completely informed about price, quality and other details)
  • Price taking behavior – if they set price above market price, none of the commodity will be sold but if price is below market price all commodities will be sold (seller՚s end)
  • Buyer՚s end – buyer wants the lowest possible price (price-taking buyer believes that if she asks for a price below the market price, no firm will be willing to sell to her)


  • Should the firm desire to sell some amount of the good, the price that it sets is exactly equal to the market price
  • Total Revenue (TR) = Market Price of Goods Firm՚s Output
  • Total revenue changes as the quantity sold changes is shown by Total Revenue Curve.
  • TR curve is an upward rising straight line (market price is fixed)
    Revenue of Perfect Competition
  • Average revenue (AR) of a firm is the total revenue per unit of output (for a price-taking firm, average revenue equals the market price)
  • Price line or Average Revenue is horizontal straight line (demand curve is perfectly elastic - firm can sell as many units of the good as it wants to sell at price p)
    The Average Revenue
  • Marginal revenue (MR) of a firm is the increase in total revenue for a unit increase in the firm՚s output or
  • For the perfectly competitive firm,

Profit Maximization

  • Firm՚s profit () = (total revenue – total cost)
  • The firm would like to identify the quantity q0 at which its profits are maximum:
  • Case I: The price, p, must equal MC
  • Case II: Marginal cost must be non-decreasing at q0
  • Case III: For the firm to continue to produce, in the short run, p > AVC; in long run, p > AC
  • Case I: Profits are maximum at a level of output (q0) where , for perfectly competitive firm , so profit maximizing output becomes level of output for which
  • Case II: Profit-maximizing output level is positive (q1 cannot be profit maximizing)
    The Profit Maximization
  • Output level of a profit maximizing firm cannot be q1 (marginal cost curve, MC, is downward sloping) , q2 and q3 (market price exceeds marginal cost) , or q5 and q6 (marginal cost exceeds market price) .
  • Case III: Holds when profit maximizing output level is positive

Price Must be Greater Than or Equal to AVC in the Short Run

The Price Costs
  • A profit maximizing firm, in the short run, will not produce at an output level wherein the market price is lower than the AVC.
  • Total Revenue = Oq1Ap
  • TVC = OEBq1
  • Firm՚s Profit = TR – (TVC + TFC)

Price Must be Greater Than or Equal to AC in the Long Run

Trice Must be Greater Than or Equal to AC in the Long Run
  • In the long run set-up, a firm that shuts down production has a profit of zero

Profit Maximization Problem

The Profit Maximization Problem
  • Total revenue of the firm at is the area of rectangle OpAq0 (the product of price and quantity) while the total cost at is the area of rectangle OEBq0 (the product of short run average cost and quantity) .
  • So, at , the firm earns a profit equal to the area of the rectangle EpAB.

Supply Curve of Firm

  • Quantity it chooses to sell at a given price
  • Supply Schedule: Quantity sold at various prices, technology and prices of factors remains unchanged
  • Supply Curve – levels of output that a firm chooses to produce corresponding to various of market price (technology and price unchanged)

Short Run Supply Curve

  • Determine a firm s profit-maximizing output level when the market price is greater than or equal to the minimum AVC
  • When the market price is , the output level of the firm is q1; when the market price is , the firm produces zero output
    The Short Run Supply Curve
  • For all positive output levels – AVC strictly exceeds p2

Long Run Supply Curve of Firm

  • We first determine the firm՚s profit-maximizing output level when the market price is greater than or equal to the minimum (long run) AC.
    The Long Run Supply Curve of Firm
  • Firm՚s long run supply curve is rising part of the LRMC curve from and above the minimum LRAC together with zero output for all prices less than the minimum LRAC

Shut down Point

  • In the short run the firm continues to produce as long as the price remains greater than or equal to the minimum of AVC.
  • Last price-output combination at which the firm produces positive output is the point of minimum AVC where the SMC curve cuts the AVC curve – below this there is no production and called as shut down point in short run (in long run it is minimum LRAC)
  • Profit
  • Normal Profit – minimum level of profit to keep firm in existing business
  • Super-normal profit – profit that firm earns over and above the normal profit
  • Break Even Point – Point on supply curve at which firm earns only normal profit (minimum average cost at which the supply curve cuts the LRAC curve or SAC curve)
  • Opportunity cost of some activity is the gain foregone from the second best activity
  • Determinants of Supply Curve for Firm
  • Technological progress is expected to shift the supply curve of a firm to the right. Subsequent to an organizational innovation by the firm, the same levels of capital and labour now produce more units of output
  • An increase (decrease) in input prices is expected to shift the supply curve of a firm to the left (right) .
  • The imposition of a unit tax shifts the supply curve of a firm to the left. A unit tax is a tax that the government imposes per unit sale of output.

Market Supply Curve

  • The market supply curve is obtained by the horizontal summation of the supply curves of individual firms. (q5 = q3 + q4)
    The Market Supply Curve
  • Market supply curve is derived for fixed number of firms; as number of firm changes – market supply curve shifts as well

Price Elasticity of Supply

  • The price elasticity of supply of a good is the percentage change in quantity supplied due to one per cent change in the market price of the good.
  • When the supply curve is vertical, supply is completely insensitive to price and the elasticity of supply is zero. In other cases, when supply curve is positively sloped, with a rise in price, supply rises and hence, the elasticity of supply is positive.
  • In case 1: Mq0 > Oq0 (price elasticity greater than 1)
  • In case 3: Mq0 < Oq0 (price elasticity less than 1)
  • In case 2: Mq0 = Oq0 (price elasticity equal to 1)
The Price Elasticity of Supply

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