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

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NCERT Class 12 Economics Chapter 4: Theory of The Firm Under Perfect Competition|CBSE|English

Perfect Competition

  • 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)

Revenue

Illustration: Revenue
Theory of the Firm under Perfect Competition Theory of the Firm under Perfect Competition
Boxes soldTR (in ₹)
00
110
220
330
440
550
  • 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)
  • Let the market for candles be perfectly competitive and let the market price of a box of candles be ₹ 10
  • When the output is one unit (horizontal distance ) , the total revenue (vertical height ) is . Therefore, the slope of the straight line is
Illustration: Revenue
  • 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)
  • 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, MR = AR = p
  • This horizontal straight line is called the price line. It is also the firm՚s AR curve under perfect competition
  • Total revenue from the sale of 2 boxes of candles is ₹ 20. Total revenue from the sale of 3 boxes of candles is ₹ 30.
  • Consider the situation when the firm՚s output changes from to . Given the market price p, MR
  • Thus, for the perfectly competitive firm, MR = AR = p
  • Key concept - When a firm increases its output by one unit, this extra unit is sold at the market price. Hence, the firm՚s increase in total revenue from the one-unit output expansion – that is, MR – is precisely the market price.

Profit Maximization

Illustration: Profit Maximization

Firm՚s profit (π) = TRTC (total revenue – total cost)

The firm would like to identify the quantity at which its profits are maximum:

  • Case I: The price, p, must equal MC
  • Case II: Marginal cost must be non-decreasing at
  • Case III: For the firm to continue to produce, in the short run, p > AVC; in long run, p > AC

Condition 2

  • Case I: Profits are maximum at a level of output where MR = MC, for perfectly competitive firm MR = p, so profit maximizing output becomes level of output for which p = MC (if MR > MC – profits increase; if MC > MR, losses occur)
  • Case II: Profit-maximizing output level is positive ( cannot be profit maximizing)
  • The firm՚s profit at an output level slightly smaller than exceeds that corresponding to the output level . This being the case, cannot be a profit-maximising output level.
  • If there is a positive level of output at which a firm՚s profit is maximised in the short run, three conditions must hold at that output level
    • p = SMC
    • SMC is non-decreasing
    • p AVC.
  • If there is a positive level of output at which a firm՚s profit is maximised in the long run, three conditions must hold at that output level
    • p = LRMC
    • LRMC is non-decreasing
    • p LRAC.
  • Output level of a profit maximizing firm cannot be (marginal cost curve, MC, is downward sloping) , and (market price exceeds marginal cost) , or and (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

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

A profit maximizing firm, in the short run, will not produce at an output level wherein the market price is lower than the AVC.

Why cannot be profit maximizing level

Total Revenue

TVC =

Firm՚s Profit = TR – (TVC + TFC)

If output is zero then TR and TVC is zero so profit =- TFC

So, profit will be EBAp-TFC which is strictly less than what it obtains by not producing at all. So, firm will choose not to produce and exit market

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

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

TR

TC =

Since firm incurs losses at output .

In the long run set-up, a firm that shuts down production has a profit of zero. Firm chooses to exit in this case

Profit Maximization Problem

Illustration: Profit Maximization Problem
  • Total revenue of the firm at is the area of rectangle (the product of price and quantity) while the total cost at is the area of rectangle (the product of short run average cost and quantity) .
  • So, at , the firm earns a profit equal to the area of the rectangle EpAB.
  • If there is a positive level of output at which a firm՚s profit is maximised in the short run, three conditions must hold at that output level
    • p = SMC
    • SMC is non-decreasing
    • .

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

Illustration: 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 ; when the market price is , the firm produces zero output
  • For all positive output levels – AVC strictly exceeds - it cannot be the case that firm supplies a positive output
  • Firms short run supply curve is the rising part of SMC curve from and above the minimum AVC together with zero output for all prices strictly less than the minimum AVC
  • Line of SMC above AVC represent long run supply curve of the firm

Long Run Supply Curve of Firm

Illustration: 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.
  • 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
  • When the market price is firm supplies in long run become an output equal .
  • For all positive output levels – LRAC strictly exceeds - it cannot be the case that firm supplies a positive output – when market price is , firm produces zero output.
  • Line of LRMC above LRAC represent long run supply curve of the firm

Shut down Point

Illustration: Shut down Point
Illustration: 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)
  • In long run firm does not produce if it earns anything less than normal profit. In short run it may produce even if the profit is less than this.
  • Opportunity cost of some activity is the gain foregone from the second-best activity – invest in family business vs bank fixed deposit with 10% (investing in business is amount if forgone interest)

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) .
  • If price of input increases, cost of production rises. Increase in average cost at any level is accompanied by increase in marginal cost at any output level – that is there is leftward or upward shift of MC curve. It implies firm supplies fewer unit of output.
  • 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

Illustration: Market Supply Curve
  • The market supply curve is obtained by the horizontal summation of the supply curves of individual firms.
  • 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

Illustration: 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: (price elasticity greater than 1)
    • In case 3: (price elasticity less than 1)
    • In case 2: (price elasticity equal to 1)

Manishika