CHAPTER-4: THE THEORY OF FIRM UNDER PERFECT COMPETITION

I. Choose the correct answer. (Each question carries 1 mark)

1. The products in a perfectly competitive market are
a) Heterogeneous products b) Homogeneous products c) Luxury goods d) Necessary goods
Ans: b) Homogeneous products
2. The increase in Total revenue for a unit increase in the output is
a) Marginal Revenue b) Average Revenue c) Total Revenue d) Fixed Revenue
Ans: a) Marginal Revenue
3. A book seller sells 30 books at the price of Rs.10 each. The Total Revenue of the seller is
a) Rs.100 b) Rs.200 c) Rs.300 d) Rs.400
Ans: c) Rs.300
4. A firm’s profit is denoted by
a) Σ b) Δ c) Φ d) π
Ans: d) π
5. When the supply curve is vertical, the elasticity of supply is as follows
a) es = 1 b) es >1 c) es = 0 d) es = ∞
Ans: c) es = 0
II. Fill in the blanks. (Each question carries 1 mark)
1. Price taking behaviour is the distinguishing characteristic of ________market.
2. For a price taking firm marginal revenue is equal to ____________
3. The minimum point of AVC where the SMC curve cuts the AVC curve is called________
4. __________cost of some activity is the gain foregone from the second best activity.
5. __________is a tax that the Government imposes per unit sale of output.
Answers: 1- Perfect competitive; 2 –Market Price; 3 – Shut down point; 4- Opportunity; 5-Unit
tax
III. Match the following. (Each question carries 1 mark)

A B
1) MR a) Perfect information
2) π b) Zero profit
3) AR c) ΔTR/ΔQ
4) Normal profit d) TR-TC
5) Perfect competition e) TR/Q
Ans: 1 - (c); 2 - (d); 3 - (e); 4 – (b); 5 – (a)
IV. Answer the following questions in a sentence/word. (Each question carries 1 mark)
1. Write the formula to calculate Average Revenue.
Ans: We calculate Average Revenue, by dividing Total revenue by the quantity sold. The following
formula is used: AR = TR/q
2. Define Marginal Revenue.
Ans: Marginal Revenue of a firm is defined as the increase in total revenue for a unit increase in the
firm’s output. It is obtained by dividing the Change in Total Revenue by Change in quantity.
3. What is Supply?
Ans: Supply of a firm refers to the quantity that it chooses to sell at a given price, given technology
and given prices of factors of production.
4. What is Normal profit?
Ans: The minimum level of profit that is needed to keep a firm in the existing business is called as
normal profit.
5. Give the meaning of Super Normal profit.
Ans: Profit that a firm earns over and above the normal profit is called as super normal profit.
6. To which side does a supply curve shift due to the technological progress?
Ans: The supply curve shifts to the right due to the technological progress.
V. Answer the following questions in about 4 sentences. (Each question carries 2 marks)
1. State the conditions needed for profit maximization by a firm under Perfect competition.
Ans: The following conditions needed for profit by a firm under perfect competition:
a) Price (P) must be equal to MC
b) Marginal cost must be non-decreasing at q0.
c) For the firm to continue to produce, in the short run, price must be greater than the average variable
cost and in the long run, price must be greater than the average cost
2. Give the meaning of Shut down point.
Ans: In the short run, the shut down point is that point of minimum Average Variable Cost where
Short run Marginal Cost curve cuts the Average Variable Cost curve. In the long run, the shut down
point is the minimum of Long Run Average Cost Curve.
3. Write the meaning of Opportunity cost with example.
Ans: Opportunity cost of some activity is the gain foregone from the second best alternative activity.
For example, let’s say you had two options to invest your money in – either your family business or
in a bank and you decide to invest in your family business. What is the opportunity cost of your
action? The opportunity cost is the amount of forgone interest from a bank (which could have given
you an interest of 10% on the deposit).
4. Mention the two determinants of a firm’s Supply curve.
Ans: The two determinants of a firm’s supply curve are as follows: (a) Technological progress (b)
Input prices.
5. Find out the Market supply when the supply curves of two producers are S1(p) = p – 20 and
S2(p) = p - 10 respectively.
Ans: Market Supply = S1 + S2
= (p-20) + (p-10)
= 2p- 30
6. Give the meaning of Price elasticity of supply and write its formula.
Ans: The price elasticity of supply refers to the proportionate change in quantity supplied to a
proportionate change in price of a commodity.
Percentage change in quantity supplied ∆𝑄 𝑃
PES = Percentage change in price
OR 𝑄
x ∆𝑃
VI. Answer the following questions in about 12 sentences. (Each question carries 4 marks)
1. Explain the features of Perfect competition.
INTRODUCTION
Perfect competition is a market where there will be existence of large number of buyers and sellers
dealing with homogenous products. It is a market with highest level competition.
a) Large number of sellers and sellers: The first condition which a perfectly competitive market
must satisfy is concerned with the sellers’ side of the market. The market must have such a large
number of sellers that no one seller is able to dominate in the market. No single firm can influence
the price of the commodity. The sellers will be the firms producing the product for sale in the market.
These firms must be all relatively small as compared to the market as a whole. Their individual
outputs should be just a fraction of the total output in the market.
There must be such a large number of buyers that no one buyer is able to influence the
market price in any way. Each buyer should purchase just a fraction of the market supplies. Further
the buyers should have any kind of union or association so that they compete for the market demand
on an individual basis.
b) 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 considered to be
identical by all the buyers in the market. There should not be any differentiation of products by
sellers by way of quality, colour, design, packing or other selling conditions of the product.
c) Free Entry and Free exit for firms: Under perfect competition, there is absolutely no restriction
on entry of new firms in the industry or the exit of the firms from the industry which want to leave.
This condition must be satisfied especially for long period equilibrium of the industry. If these four
conditions are satisfied, the market is said to be purely competitive. In other words, a market
characterized by the presence of these four features is called purely competitive. For a market to be
perfect, some conditions of perfection of the market must also be fulfilled.
d) Price Taker: The single distinguishing character of perfect competition is the price taking
behaviour of the firms. 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. 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.
e) Information is perfect: 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.
Since all firms produce the same good and all buyers are aware of the market price, the firm in
question loses all its buyers if it rises price.
2. Write about the third condition of profit maximization of the firm under perfect competition
with the help of diagrams.
INTRODUCTION 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.
Case 1: 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.
Observe that at the output level q1, the market price p is lower than the AVC.
Total Revenue of this firm at q1 is as follows:
TR= P x Q
= Op x Oq1= Area of Rectangle OpAq1
Similarly, the firm’s TVC at q1 is as follows
TVC = AVC x Quantity
= OE x Oq
= Area of Rectangle OEBq1
Firm’s Profit at q1is = TR – (TVC+TFC)
= OpAq1 – OEBq1 – (TFC)
The area of rectangle OpAq1 is strictly less than the area of rectangle OEBq1. Hence, the firm’s profit
at q1 is [(area EBAp) - TFC] strictly less than what it obtains by not producing at all. So, the firm will
choose not to produce at all and exit from the market.
Case 2: Price must be greater than or equal to AC in the Long Run: In the long-run setup, a firm
that shuts down production has a profit of zero. Again the firm chooses to exit in this case.

A profit maximizing firm will not produce at an output level where the market price is lower than AC.
At output level q1, p<AC.
Total Revenue of this firm at q1 is as follows:
TR = OpAq1 (product of price and quantity).
Similarly, the firm’s TC at q1 is as follows:
TC = OEBq1.
As TC > TR, the firm incurs loss at the output level [Link] the long run, if the firm makes not profit, it
has to shut down & exit.
3. The following table shows the total revenue and total cost schedules of a competitive firm.
Calculate the profit at each output level and determine the market price of the good.
Quantity TR(Rs.) TC(Rs.) Profit Market Price
sold (q)
0 0 5
1 5 7
2 10 10
3 15 12
4 20 15
5 25 23
6 30 33
7 35 40

Ans: Profit = TR-TC, Market Price = TR/Q

Quantity TR(Rs.) TC(Rs) Profit Market Price

sold (q)
0 0 5 -5 -
1 5 7 -2 5
2 10 10 0 5
3 15 12 3 5
4 20 15 5 5
5 25 23 2 5
6 30 33 -3 5
7 35 40 -5 5

4. Write about Shut down point, Normal profit and Break-even point.
INTRODUCTION – There are situations where the firm encounters decisions about whether to
continue to produce or not in the short run as well as in the long run. Let us look into three different
scenarios where firms will be able to decide on that.
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. Therefore, along the supply curve as we move down, the 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 will be no production. This point is
called the short run shut down point of the firm. However, in the long run, the shut down point is the
minimum of LRAC curve.
Normal Profit: The minimum level of profit that is needed to keep a firm in the existing business is
defined as normal profit. A firm that does not make normal profits is not going to continue in
business. Normal profits are therefore a part of the firm’s total costs. It may be useful to think of them
as an opportunity cost for entrepreneurship. Profit that a firm earns over and above the normal profit
is called super normal profit.
Break Even Point: In the long run, the firm does not produce if it earns anything less than the normal
profit. In the short run, however, it may produce even if he profit is less than this level. The point on
the supply curve at which a firm earns normal profit is called the Break Even Point of the firm. The
point of minimum average cost at which the supply cure cuts the LRAC curve is therefore the break-
even point of the firm.
5. Explain the determinants of a firm’s supply curve.
INTRODUCTION A firm’s marginal cost 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 two factors
determining a firm’s supply curve:
a) Technological Progress: The organizational innovation by the firm leads to more production of
output. That means, to produce a given level of output, the organizational innovation allows the firm
to use fewer units of inputs. It is expected that this will lower the firm’s marginal cost at any level of
output, i.e., there is a rightward shift of the MC curve. 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. If the price of input (ex, 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 at any level of output which leads to upward shift of the MC
curve. That means, the firm’s supply curve shifts to the left and the firm produces less quantity of
output.
6. Assume that 200 balls are produced by the firm at the market price Rs.10 for each ball. When
the price of ball rises to Rs.30, firm produces 1000 balls. Find the Price elasticity of supply?
Ans: In a perfectly competitive market, let’s assume the price of cricket balls is Rs.10 and, 200 balls
are produced in aggregate by all the firms in the market. When the price of the ball changes to Rs.30
let’s assume that quantity supplied increases to 1,000 units (all firms put together)
So, P1 = 10 Q1 = 200
P2 = 30 Q2 = 1,000
Percentage change in quantity supplied = ((1000-200)/200) x 100 = 400
Percentage change in price = ((30-10)/10) x 100 = 200
So, Price Elasticity of Supply = 400/200
=2
VII. Answer the following questions in about 20 sentences. (Each question carries 6 marks)
1. Write about Total revenue and Average revenue of a firm under Perfect competition with
diagrams.
INTRODUCTION A firm earns revenue by selling the good that it produces in the market. Let the
market price of a unit of the good be ‘p’. Let the „q‟ be the quantity of the good produced and sold by
the firm at price ‘p’. Then the Total Revenue and Average Revenue can be discussed as follows:
Total Revenue (TR): The total revenue is defined as the market price (p) of the good multiplied by the
firm’s output (q). Then, TR= p x q.
In a perfectly competitive market, a firm views the market price ‘p’ as given, With the market
price fixed at ‘p’ the TR curve of a firm shows the relationship between its Total Revenue (y axis) and
its total output (x axis). The following diagram shows the Total Revenue Curve of a firm.
 There are three observations we must make. Firstly, when the output is zero, Total Revenue of
the firm is also zero. Therefore, TR curve passes through point O. Secondly, the TR increases as the
output goes up. Moreover, the equation TR= p x q is that of a straight line. This means that the TR
curve is an upward rising straight line. Thirdly, consider the slope of the straight line. When the output
is 1 unit (horizontal distance Oq1 in the above diagram), the Total Revenue (vertical height Aq1) is
Aq1
px1=p. Therefore, the slope of the straight line is Oq1
= 𝑃.

Average Revenue: The average revenue (AR) of a firm is defined as Total Revenue per unit of output.
𝑇𝑅 𝑃×𝑞
This can be represented as follows: AR = = = 𝑃 . For a price taking firm, average revenue
𝑞 𝑞
equals the market price. Diagrammatically the AR curve can be represented as follows:

In the above diagram, we plot the market price(y axis), for different values of a firm’s output (x
axis). 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. The price line shows the
relationship between market price and the firm’s output level. The vertical height of the price line is
equal to the market price p. The price line also depicts the demand curve facing a firm. Observe that the
diagram shows that the market price, p, is independent of a firm’s output. This means that the firm can
sell as many units of the goods as it wants to sell at price p.
Marginal revenue – is defined as the increase in TR for a unit increase in the firm’s output.
MR = Change in TR / Change in Q
In perfect competition, AR = MR = P
In other words, for a price-taking firm, MR equals the market price
2. Explain the profit maximization of a firm under the following conditions.
a) P = MC b) MC must be non-decreasing at q0
INTRODUCTION 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.
Condition 1 - 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. As long as 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 as long as marginal
revenue is greater than marginal cost, profits are increasing and as long as marginal revenue is less
than marginal cost, profits will fall. It follows that for profits to be maximum, marginal revenue
should be equal to marginal cost. 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.
Condition 2 - Marginal cost must be non-decreasing at qo: 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:

In the above diagram, at output levels q1 and q4 the market price is equal to the marginal cost.
However, at the output level q1 the marginal cost curve is downward sloping. If we observe all output
levels to the left of q1 the market price is lower than the marginal cost. Therefore, q1 cannot be a profit
maximizing output level. However at q4, MC is non-decreasing and hence can be considered as the
output level which satisfies both conditions. At output levels q2 and q3 market price exceeds marginal
cost and at output levels q5 and q6 marginal cost exceeds market price.
3. Analyse the short run supply curve of a firm with the help of a diagram.
INTRODUCTION Supply of a firm refers to the quantity that it chooses to sell at a given price,
given technology and given prices of factors of production. 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.
The derivation of supply curve can be split into two parts viz., firm’s profit maximizing output level
when the market price is greater than or equal to minimum Average Variable Cost and the 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
 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.
4. Illustrate the Long run supply curve of a firm with the help of a diagram.
INTRODUCTION Supply of a firm refers to the quantity that it chooses to sell at a given price,
given technology and given prices of factors of production. 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.
Let us derive a firm’s long run supply curve. The derivation of supply curve can be split into two parts
viz., firm’s profit maximizing output level when the market price is greater than or equal to minimum
Average Cost and the firm’s profit maximizing output level when the market price is less than the
minimum Average Cost.
Case 1: Price greater than or equal to the minimum LRAC: This can be explained with the help of
the following diagram

If the market price is p1 which exceeds the minimum LRAC. Upon equating p1 with the rising part of
LRMC, we obtain output of q1. Note also that the LRAC at q1 does not exceed the market price, p1.
Thus all three conditions are highlighted in section 3 satisfied at q1. Hence, when the market price is
p1, the firm’s supplies in the long run become an output equal to q1.
Case -2: Price is less than minimum LRAC: If the market price is p2, which is less than the
minimum LRAC firm produces zero output. It is because to produce positive level of output in the
long run, price must be greater than or equal to the minimum LRAC.
Combining both cases mentioned in the previous slide (prices p1 & p2).The firm’s long run supply
curve is the rising part of the LRMC curve. From & above the minimum LRAC together with zero
output. For all prices less than minimum LRAC.

The long run supply curve of a firm, which is based on its long run marginal cost curve (LRMC) and
long run average cost curve (LRAC), is represented by the bold line.
5. Explain Market supply curve with the help of diagram.
INTRODUCTION – A firm’s supply curve is a part of its marginal cost curve. A combination of
two or more individual supply curves will give rise to a market supply curve.
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 3 firms - firm 1, firm 2, firm 3 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:

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.
VIII. Assignment and Project Oriented Question. (5 Marks)
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.60.

Quantity Sold 0 1 2 3 4 5
TR
MR
AR
Ans: Hint: For TR Multiply Price and Quantity (PxQ); MR = TRn-TRn-1 and AR = TR/Q
Quantity sold TR MR AR
0 0 - -
1 60 60 60
2 120 60 60
3 180 60 60
4 240 60 60
5 300 60 60
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