Test: Theory Of The Firm Under Perfect Competition - UPSC MCQ

Producer's Equilibrium: Equilibrium refers to a state of rest when no change is required. A firm (producer) is said to be in equilibrium when it has no inclination to expand or to contract its output. This state either reflects maximum profits or minimum losses. Producer’s equilibrium is often explained in terms of marginal revenue (MR) and marginal cost (MC) of production. Profit is maximized (or a producer strikes his equilibrium) when two conditions are satisfied – (i) MR = MC, and (ii) MC is rising (or MC is greater than MR beyond the point of equilibrium output)

This strategy is based on the fact that the total profit reaches its maximum point where marginal revenue equals marginal profit. This is the case because the firm will continue to produce until marginal profit is equal to zero, and marginal profit equals the marginal revenue (MR) minus the marginal cost (MC).

Pure or perfect competition is a theoretical market structure in which the following criteria are met: All firms sell an identical product (the product is a "commodity" or "homogeneous"). All firms are price takers (they cannot influence the market price of their product). Market share has no influence on prices.

Answer:

Market situation: Perfect competition

Explanation:

1. Characteristics of perfect competition:

• A large number of buyers and sellers


• Homogeneous products


• Perfect knowledge and information


• No barriers to entry or exit


• Price takers - firms have no control over the price

2. Demand curve in perfect competition:

• Perfectly competitive firms face a perfectly elastic demand curve.


• The demand curve is horizontal or parallel to the X-axis because the firm can sell as much as it wants at the market price.


• The price is determined by the market forces of supply and demand, and individual firms have no influence on it.


• If a firm tries to charge a higher price, buyers will shift their demand to other firms in the market.


• If a firm tries to charge a lower price, it will not be able to sell any additional quantity because buyers can already purchase as much as they want at the market price.

3. Linear demand curve:

• A linear demand curve is a straight line on a graph, indicating a constant rate of change in quantity demanded for each unit change in price.


• In perfect competition, the demand curve is linear because the price remains constant regardless of the quantity demanded by the firm.


• As the firm increases its output, it can sell all the additional units at the market price.

Therefore, in a market situation of perfect competition, the demand curve is linear and parallel to the X-axis.

In a monopolistic market, there is only one firm that produces a product. There is absolute product differentiation because there is no substitute. The marginal cost of production is the change in the total cost that arises when there is a change in the quantity produced. The marginal revenue is the change in the total revenue that arises when there is a change in the quantity produced. a firm maximizes its total profit by equating marginal cost to marginal revenue and solving for the price of one product and the quantity it must produce.

Supernormal profit is defined as extra profit above that level of normal profit. Supernormal profit is also known as abnormal profit. Abnormal profit means there is an incentive for other firms to enter the industry.

MR curve=AR=Demand curve is a feature of which kind of market?
The feature of MR curve=AR=Demand curve is characteristic of a perfect competition market. In a perfect competition market, there are numerous buyers and sellers of homogeneous products. Here is a detailed explanation:
1. Perfect competition:
- Perfect competition is a market structure where there are many buyers and sellers.
- The products sold in this market are identical or homogeneous, meaning they are indistinguishable from each other.
- There is free entry and exit of firms in the market, allowing for easy competition.
- The information is perfect, and all participants have full knowledge of prices and market conditions.
- In perfect competition, firms are price takers, meaning they cannot influence the market price.
- The demand curve faced by a firm in perfect competition is perfectly elastic, i.e., horizontal.
- Marginal revenue (MR) is equal to average revenue (AR), which is equal to the demand curve.
2. MR curve=AR=Demand curve:
- In perfect competition, since the firm is a price taker, it can only sell its output at the prevailing market price.
- The demand curve faced by the firm is perfectly elastic, meaning any change in quantity will not affect the price.
- Consequently, the average revenue (AR) curve, which represents the price at which the firm sells its output, is a horizontal line.
- Since the firm can sell additional units only at the prevailing market price, the marginal revenue (MR) curve is also horizontal and coincides with the AR curve.
- Therefore, in perfect competition, the MR curve, AR curve, and demand curve are all the same.
Conclusion:
- The feature of MR curve=AR=Demand curve is unique to perfect competition.
- In other market structures like oligopoly, monopolistic competition, and monopoly, the MR curve, AR curve, and demand curve are not equal.
- Thus, the correct answer to the question is A: Perfect competition.

Under perfect competition, the price is determined by the market forces of demand and supply. If the price lies below the average cost curve, it means that the firm is selling its product at a price that is lower than the average cost of production. In such a scenario, the firm would incur losses because its costs of production would be higher than the revenue it earns from selling the product.
Here is a detailed explanation of why the firm would incur losses:
1. Price determination under perfect competition:
- In perfect competition, the price is determined by the equilibrium point of demand and supply in the market.
- The firm is a price taker and has no control over the price.
- It can only adjust its quantity of output to maximize its profits.
2. Average cost curve and profit:
- The average cost curve represents the average cost of production per unit of output.
- It is U-shaped, with economies of scale in the beginning and diseconomies of scale at higher levels of output.
- The average cost curve intersects with the marginal cost curve at its minimum point.
- If the price is below the average cost curve, it means that the firm is unable to cover its costs of production.
3. Losses in the short run:
- In the short run, the firm has fixed costs that it cannot change.
- It can only adjust its variable costs by changing the quantity of output.
- If the price is below the average cost curve, the firm's total revenue will be less than its total costs, resulting in losses.
4. Shutdown point:
- If the price falls below the average variable cost curve, the firm should shut down in the short run.
- By shutting down, the firm avoids incurring any further losses.
- However, it still incurs its fixed costs.
In conclusion, if the price lies below the average cost curve under perfect competition, the firm would incur losses in the short run. It is important for the firm to assess its costs and the prevailing market price to make informed decisions about its production and profitability.

For a firm to achieve long run equilibrium, the marginal cost must be equal to the price and the long run average cost. That is, LMC = LAC = P. The firm adjusts the size of its plant to produce a level of output at which the LAC is minimum.

Monopolistic competition is a market structure which combines elements of monopoly and competitive markets. Essentially a monopolistic competitive market is one with freedom of entry and exit, but firms can differentiate their products. Because there is freedom of entry, supernormal profits will encourage more firms to enter the market leading to normal profits in the long term.