NCERT Textbook - The Theory of the Firm under Perfect Competition (Microeconomics) | Indian Economy for UPSC CSE PDF Download

 Page 1


Chapter 4
The Theor The Theor The Theor The Theor The Theory of the F y of the F y of the F y of the F y of the Firm irm irm irm irm
under P under P under P under P under Per er er er erfect Competition fect Competition fect Competition fect Competition fect 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
uncontroversial. 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. Here, we also assume that the firm sells whatever it produces
so that ‘output’ and quantity sold are often used interchangebly.
The structure of this chapter is as follows. We first set up and
examine in detail the profit maximisation problem of a firm. Then,0
we derive a firm’s supply curve. The supply curve shows the levels
of output that a firm chooses to produce at different  market prices.
Finally, we study how to aggregate the supply curves of individual
firms and obtain the market supply curve.
4.1 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 the following
defining features:
1. The market consists of a large number of buyers and sellers
2. 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.
3. Entry into the market as well as exit from the market are free
for firms.
4. Information is perfect.
The existence of a large number of buyers and sellers means
that each individual buyer and seller is very small compared to
the size of the market. This means that no individual buyer or
seller can influence the market by their size. Homogenous products
further mean that the product of each firm is identical. So a buyer
can choose to buy from any firm in the market, and she gets the
same product. Free entry and exit mean that it is easy for firms to
enter the market, as well as to leave it. This condition is essential
Reprint 2024-25
Page 2


Chapter 4
The Theor The Theor The Theor The Theor The Theory of the F y of the F y of the F y of the F y of the Firm irm irm irm irm
under P under P under P under P under Per er er er erfect Competition fect Competition fect Competition fect Competition fect 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
uncontroversial. 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. Here, we also assume that the firm sells whatever it produces
so that ‘output’ and quantity sold are often used interchangebly.
The structure of this chapter is as follows. We first set up and
examine in detail the profit maximisation problem of a firm. Then,0
we derive a firm’s supply curve. The supply curve shows the levels
of output that a firm chooses to produce at different  market prices.
Finally, we study how to aggregate the supply curves of individual
firms and obtain the market supply curve.
4.1 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 the following
defining features:
1. The market consists of a large number of buyers and sellers
2. 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.
3. Entry into the market as well as exit from the market are free
for firms.
4. Information is perfect.
The existence of a large number of buyers and sellers means
that each individual buyer and seller is very small compared to
the size of the market. This means that no individual buyer or
seller can influence the market by their size. Homogenous products
further mean that the product of each firm is identical. So a buyer
can choose to buy from any firm in the market, and she gets the
same product. Free entry and exit mean that it is easy for firms to
enter the market, as well as to leave it. This condition is essential
Reprint 2024-25
54
Introductory
Microeconomics
for the large numbers of firms to exist. If entry was difficult, or restricted, then
the number of firms in the market could be small. Perfect information implies
that all buyers and all sellers are completely informed about the price, quality
and other relevant details about the product, as well as the market.
These features result in the single most distinguishing characteristic of perfect
competition: price taking behaviour. From the viewpoint of a firm, what does
price-taking entail? 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, 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 price-taking entail? A buyer would obviously like to buy
the good at the lowest possible price. However, a price-taking buyer believes that
if she asks 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.
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 where each firm in the market
charges the same (market) price. 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 demand is readily accommodated when there
are so many other 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.
4.2 REVENUE
We have indicated that in a perfectly competitive market, a firm believes that it
can sell as many units of the good as it wants by setting a price less than or equal
to the market price. But, if this is the case, surely there is no reason to set a price
lower than the market price. In other words, should the firm desire to sell some
amount of the good, the price that it sets is exactly equal to the market price.
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 q be the quantity of the good
produced, and therefore sold, by the firm at price p. Then, total revenue (TR) of
the firm is defined as the market price of the good (p) multiplied by the firm’s
output (q). Hence,
TR = p × q
To make matters concrete, consider the following numerical example. Let the
market for candles be perfectly competitive and let the market price of a box of
candles be Rs 10. For a candle manufacturer,
Table 4.1 shows how total revenue is related to
output. Notice that when no box is sold,
TR is equal to zero; if one box of candles is sold,
TR is equal to 1×Rs 10= Rs 10; if two boxes of
candles are produced, TR is equal to 2 × Rs 10
= Rs 20; and so on.
We can depict how the total revenue changes
as the quantity sold changes through a Total
Revenue Curve. A total revenue curve plots
Boxes sold  TR (in Rs)
Table 4.1: Total Revenue
0 0
1 10
2 20
3 30
4 40
5 50
Reprint 2024-25
Page 3


Chapter 4
The Theor The Theor The Theor The Theor The Theory of the F y of the F y of the F y of the F y of the Firm irm irm irm irm
under P under P under P under P under Per er er er erfect Competition fect Competition fect Competition fect Competition fect 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
uncontroversial. 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. Here, we also assume that the firm sells whatever it produces
so that ‘output’ and quantity sold are often used interchangebly.
The structure of this chapter is as follows. We first set up and
examine in detail the profit maximisation problem of a firm. Then,0
we derive a firm’s supply curve. The supply curve shows the levels
of output that a firm chooses to produce at different  market prices.
Finally, we study how to aggregate the supply curves of individual
firms and obtain the market supply curve.
4.1 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 the following
defining features:
1. The market consists of a large number of buyers and sellers
2. 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.
3. Entry into the market as well as exit from the market are free
for firms.
4. Information is perfect.
The existence of a large number of buyers and sellers means
that each individual buyer and seller is very small compared to
the size of the market. This means that no individual buyer or
seller can influence the market by their size. Homogenous products
further mean that the product of each firm is identical. So a buyer
can choose to buy from any firm in the market, and she gets the
same product. Free entry and exit mean that it is easy for firms to
enter the market, as well as to leave it. This condition is essential
Reprint 2024-25
54
Introductory
Microeconomics
for the large numbers of firms to exist. If entry was difficult, or restricted, then
the number of firms in the market could be small. Perfect information implies
that all buyers and all sellers are completely informed about the price, quality
and other relevant details about the product, as well as the market.
These features result in the single most distinguishing characteristic of perfect
competition: price taking behaviour. From the viewpoint of a firm, what does
price-taking entail? 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, 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 price-taking entail? A buyer would obviously like to buy
the good at the lowest possible price. However, a price-taking buyer believes that
if she asks 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.
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 where each firm in the market
charges the same (market) price. 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 demand is readily accommodated when there
are so many other 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.
4.2 REVENUE
We have indicated that in a perfectly competitive market, a firm believes that it
can sell as many units of the good as it wants by setting a price less than or equal
to the market price. But, if this is the case, surely there is no reason to set a price
lower than the market price. In other words, should the firm desire to sell some
amount of the good, the price that it sets is exactly equal to the market price.
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 q be the quantity of the good
produced, and therefore sold, by the firm at price p. Then, total revenue (TR) of
the firm is defined as the market price of the good (p) multiplied by the firm’s
output (q). Hence,
TR = p × q
To make matters concrete, consider the following numerical example. Let the
market for candles be perfectly competitive and let the market price of a box of
candles be Rs 10. For a candle manufacturer,
Table 4.1 shows how total revenue is related to
output. Notice that when no box is sold,
TR is equal to zero; if one box of candles is sold,
TR is equal to 1×Rs 10= Rs 10; if two boxes of
candles are produced, TR is equal to 2 × Rs 10
= Rs 20; and so on.
We can depict how the total revenue changes
as the quantity sold changes through a Total
Revenue Curve. A total revenue curve plots
Boxes sold  TR (in Rs)
Table 4.1: Total Revenue
0 0
1 10
2 20
3 30
4 40
5 50
Reprint 2024-25
55
The Theory of the Firm
under Perfect Competition
the quantity sold or output on the
X-axis and the Revenue earned on
the Y-axis. Figure 4.1 shows the
total revenue curve of a firm. Three
observations are relevant here.
First, when the output is zero, the
total revenue of the firm is also
zero. Therefore, the TR curve
passes through point O. Second,
the total revenue increases as the
output goes up. Moreover, the
equation ‘TR = p  × q’ is that of a
straight line because p is constant.
This means that the TR curve is
an upward rising straight line.
Third, consider the slope of this
straight line. When the output is
one unit (horizontal distance Oq
1
in Figure 4.1), the total revenue
(vertical height Aq
1
 in Figure 4.1)
is p × 1 = p. Therefore, the slope of
the straight line is Aq
1
/Oq
1
 = p.
The average revenue ( AR ) of
a firm is defined as total revenue
per unit of output. Recall that if a
firm’s output is q and the market
price is p, then TR equals p × q.
Hence
AR = 
TR
q
 = 
p q
q
×
  = p
In other words, for a price-taking
firm, average revenue equals the
market price.
Now consider Figure 4.2.
Here, we plot the average revenue
or 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. It is also the
firm’s AR curve under perfect competition The price line also depicts the demand
curve facing a firm. Observe that the demand curve is perfectly elastic. This means
that a firm can sell as many units of the good as it wants to sell at price p.
The marginal revenue (MR) of a firm is defined as the increase in total
revenue for a unit increase in the firm’s output. Consider table 4.1 again. Total
revenue from the sale of 2 boxes of candles is Rs.20. Total revenue from the sale
of 3 boxes of candles is Rs.30.
Changeintotalrevenue 30-20
MarginalRevenue(MR)= = =10
Changeinquantity 3-2
Price Line. The price line shows the relationship
between the market price and a firm’s output level.
The vertical height of the price line is equal to the
market price, p.
Fig. 4.2
Price
Price Line
O
Output
p
Total Revenue curve. The total revenue curve of
a firm shows the relationship between the total
revenue that the firm earns and the output level of
the firm. The slope of the curve, Aq
1
/Oq
1
, is the
market price.
Fig. 4.1
Revenue
TR
O
Output
A
q
1
Reprint 2024-25
Page 4


Chapter 4
The Theor The Theor The Theor The Theor The Theory of the F y of the F y of the F y of the F y of the Firm irm irm irm irm
under P under P under P under P under Per er er er erfect Competition fect Competition fect Competition fect Competition fect 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
uncontroversial. 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. Here, we also assume that the firm sells whatever it produces
so that ‘output’ and quantity sold are often used interchangebly.
The structure of this chapter is as follows. We first set up and
examine in detail the profit maximisation problem of a firm. Then,0
we derive a firm’s supply curve. The supply curve shows the levels
of output that a firm chooses to produce at different  market prices.
Finally, we study how to aggregate the supply curves of individual
firms and obtain the market supply curve.
4.1 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 the following
defining features:
1. The market consists of a large number of buyers and sellers
2. 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.
3. Entry into the market as well as exit from the market are free
for firms.
4. Information is perfect.
The existence of a large number of buyers and sellers means
that each individual buyer and seller is very small compared to
the size of the market. This means that no individual buyer or
seller can influence the market by their size. Homogenous products
further mean that the product of each firm is identical. So a buyer
can choose to buy from any firm in the market, and she gets the
same product. Free entry and exit mean that it is easy for firms to
enter the market, as well as to leave it. This condition is essential
Reprint 2024-25
54
Introductory
Microeconomics
for the large numbers of firms to exist. If entry was difficult, or restricted, then
the number of firms in the market could be small. Perfect information implies
that all buyers and all sellers are completely informed about the price, quality
and other relevant details about the product, as well as the market.
These features result in the single most distinguishing characteristic of perfect
competition: price taking behaviour. From the viewpoint of a firm, what does
price-taking entail? 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, 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 price-taking entail? A buyer would obviously like to buy
the good at the lowest possible price. However, a price-taking buyer believes that
if she asks 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.
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 where each firm in the market
charges the same (market) price. 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 demand is readily accommodated when there
are so many other 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.
4.2 REVENUE
We have indicated that in a perfectly competitive market, a firm believes that it
can sell as many units of the good as it wants by setting a price less than or equal
to the market price. But, if this is the case, surely there is no reason to set a price
lower than the market price. In other words, should the firm desire to sell some
amount of the good, the price that it sets is exactly equal to the market price.
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 q be the quantity of the good
produced, and therefore sold, by the firm at price p. Then, total revenue (TR) of
the firm is defined as the market price of the good (p) multiplied by the firm’s
output (q). Hence,
TR = p × q
To make matters concrete, consider the following numerical example. Let the
market for candles be perfectly competitive and let the market price of a box of
candles be Rs 10. For a candle manufacturer,
Table 4.1 shows how total revenue is related to
output. Notice that when no box is sold,
TR is equal to zero; if one box of candles is sold,
TR is equal to 1×Rs 10= Rs 10; if two boxes of
candles are produced, TR is equal to 2 × Rs 10
= Rs 20; and so on.
We can depict how the total revenue changes
as the quantity sold changes through a Total
Revenue Curve. A total revenue curve plots
Boxes sold  TR (in Rs)
Table 4.1: Total Revenue
0 0
1 10
2 20
3 30
4 40
5 50
Reprint 2024-25
55
The Theory of the Firm
under Perfect Competition
the quantity sold or output on the
X-axis and the Revenue earned on
the Y-axis. Figure 4.1 shows the
total revenue curve of a firm. Three
observations are relevant here.
First, when the output is zero, the
total revenue of the firm is also
zero. Therefore, the TR curve
passes through point O. Second,
the total revenue increases as the
output goes up. Moreover, the
equation ‘TR = p  × q’ is that of a
straight line because p is constant.
This means that the TR curve is
an upward rising straight line.
Third, consider the slope of this
straight line. When the output is
one unit (horizontal distance Oq
1
in Figure 4.1), the total revenue
(vertical height Aq
1
 in Figure 4.1)
is p × 1 = p. Therefore, the slope of
the straight line is Aq
1
/Oq
1
 = p.
The average revenue ( AR ) of
a firm is defined as total revenue
per unit of output. Recall that if a
firm’s output is q and the market
price is p, then TR equals p × q.
Hence
AR = 
TR
q
 = 
p q
q
×
  = p
In other words, for a price-taking
firm, average revenue equals the
market price.
Now consider Figure 4.2.
Here, we plot the average revenue
or 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. It is also the
firm’s AR curve under perfect competition The price line also depicts the demand
curve facing a firm. Observe that the demand curve is perfectly elastic. This means
that a firm can sell as many units of the good as it wants to sell at price p.
The marginal revenue (MR) of a firm is defined as the increase in total
revenue for a unit increase in the firm’s output. Consider table 4.1 again. Total
revenue from the sale of 2 boxes of candles is Rs.20. Total revenue from the sale
of 3 boxes of candles is Rs.30.
Changeintotalrevenue 30-20
MarginalRevenue(MR)= = =10
Changeinquantity 3-2
Price Line. The price line shows the relationship
between the market price and a firm’s output level.
The vertical height of the price line is equal to the
market price, p.
Fig. 4.2
Price
Price Line
O
Output
p
Total Revenue curve. The total revenue curve of
a firm shows the relationship between the total
revenue that the firm earns and the output level of
the firm. The slope of the curve, Aq
1
/Oq
1
, is the
market price.
Fig. 4.1
Revenue
TR
O
Output
A
q
1
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56
Introductory
Microeconomics
Is it a coincidence that this is the same as the price? Actually it is not. Consider
the situation when the firm’s output changes from q
1 
to q
2
. Given the market
price p,
MR = (pq
2 
–pq
1
)/ (q
2 
–q
1
)
      = [p (q
2 
–q
1
)]/ (q
2 
–q
1
)
      = p
Thus, for the perfectly competitive firm, MR=AR=p
In other words, for a price-taking firm, marginal revenue equals the market
price.
Setting the algebra aside, the intuition for this result is quite simple. 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.
4.3 PROFIT MAXIMISATION
A firm produces and sells a certain amount of a good. The firm’s profit, denoted
by p
1
, is defined to be the difference between its total revenue (TR) and its total
cost of production (TC ). In other words
p = TR – TC
Clearly, the gap between TR and TC is the firm’s earnings net of costs.
A firm wishes to maximise its profit. The firm would like to identify the quantity
q
0
 at which its profits are maximum. By definition, then, at any quantity other
than q
0
, the firm’s profits are less than at q
0
. The critical question is: how do we
identify q
0
?
For profits to be maximum, three conditions must hold at q
0
:
1. The price, p, must equal MC
2. Marginal cost must be non-decreasing at q
0
3. For the firm to continue to produce, in the short run, price must be greater
than the average variable cost (p > AVC); in the long run, price must be greater
than the average cost (p > AC).
4.3.1 Condition 1
Profits are the difference between total revenue and total cost. Both total revenue
and total cost increase as output increases. Notice that as long as the change in
total revenue is greater than the change in total cost, profits will continue to
increase. Recall that 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. By the same logic, as long as
marginal revenue is less than marginal cost, profits will fall. It follows that for
profits to be maximum, marginal revenue should equal marginal cost.
In other words, profits are maximum at the level of output (which we have
called q
0
) for which MR = MC
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.
4.3.2 Condition 2
Consider the second condition that must hold when the profit-maximising output
level is positive. Why is it the case that the marginal cost curve cannot slope
1
It is a convention in economics to denote profit with the Greek letter p .
Reprint 2024-25
Page 5


Chapter 4
The Theor The Theor The Theor The Theor The Theory of the F y of the F y of the F y of the F y of the Firm irm irm irm irm
under P under P under P under P under Per er er er erfect Competition fect Competition fect Competition fect Competition fect 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
uncontroversial. 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. Here, we also assume that the firm sells whatever it produces
so that ‘output’ and quantity sold are often used interchangebly.
The structure of this chapter is as follows. We first set up and
examine in detail the profit maximisation problem of a firm. Then,0
we derive a firm’s supply curve. The supply curve shows the levels
of output that a firm chooses to produce at different  market prices.
Finally, we study how to aggregate the supply curves of individual
firms and obtain the market supply curve.
4.1 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 the following
defining features:
1. The market consists of a large number of buyers and sellers
2. 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.
3. Entry into the market as well as exit from the market are free
for firms.
4. Information is perfect.
The existence of a large number of buyers and sellers means
that each individual buyer and seller is very small compared to
the size of the market. This means that no individual buyer or
seller can influence the market by their size. Homogenous products
further mean that the product of each firm is identical. So a buyer
can choose to buy from any firm in the market, and she gets the
same product. Free entry and exit mean that it is easy for firms to
enter the market, as well as to leave it. This condition is essential
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Introductory
Microeconomics
for the large numbers of firms to exist. If entry was difficult, or restricted, then
the number of firms in the market could be small. Perfect information implies
that all buyers and all sellers are completely informed about the price, quality
and other relevant details about the product, as well as the market.
These features result in the single most distinguishing characteristic of perfect
competition: price taking behaviour. From the viewpoint of a firm, what does
price-taking entail? 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, 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 price-taking entail? A buyer would obviously like to buy
the good at the lowest possible price. However, a price-taking buyer believes that
if she asks 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.
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 where each firm in the market
charges the same (market) price. 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 demand is readily accommodated when there
are so many other 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.
4.2 REVENUE
We have indicated that in a perfectly competitive market, a firm believes that it
can sell as many units of the good as it wants by setting a price less than or equal
to the market price. But, if this is the case, surely there is no reason to set a price
lower than the market price. In other words, should the firm desire to sell some
amount of the good, the price that it sets is exactly equal to the market price.
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 q be the quantity of the good
produced, and therefore sold, by the firm at price p. Then, total revenue (TR) of
the firm is defined as the market price of the good (p) multiplied by the firm’s
output (q). Hence,
TR = p × q
To make matters concrete, consider the following numerical example. Let the
market for candles be perfectly competitive and let the market price of a box of
candles be Rs 10. For a candle manufacturer,
Table 4.1 shows how total revenue is related to
output. Notice that when no box is sold,
TR is equal to zero; if one box of candles is sold,
TR is equal to 1×Rs 10= Rs 10; if two boxes of
candles are produced, TR is equal to 2 × Rs 10
= Rs 20; and so on.
We can depict how the total revenue changes
as the quantity sold changes through a Total
Revenue Curve. A total revenue curve plots
Boxes sold  TR (in Rs)
Table 4.1: Total Revenue
0 0
1 10
2 20
3 30
4 40
5 50
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The Theory of the Firm
under Perfect Competition
the quantity sold or output on the
X-axis and the Revenue earned on
the Y-axis. Figure 4.1 shows the
total revenue curve of a firm. Three
observations are relevant here.
First, when the output is zero, the
total revenue of the firm is also
zero. Therefore, the TR curve
passes through point O. Second,
the total revenue increases as the
output goes up. Moreover, the
equation ‘TR = p  × q’ is that of a
straight line because p is constant.
This means that the TR curve is
an upward rising straight line.
Third, consider the slope of this
straight line. When the output is
one unit (horizontal distance Oq
1
in Figure 4.1), the total revenue
(vertical height Aq
1
 in Figure 4.1)
is p × 1 = p. Therefore, the slope of
the straight line is Aq
1
/Oq
1
 = p.
The average revenue ( AR ) of
a firm is defined as total revenue
per unit of output. Recall that if a
firm’s output is q and the market
price is p, then TR equals p × q.
Hence
AR = 
TR
q
 = 
p q
q
×
  = p
In other words, for a price-taking
firm, average revenue equals the
market price.
Now consider Figure 4.2.
Here, we plot the average revenue
or 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. It is also the
firm’s AR curve under perfect competition The price line also depicts the demand
curve facing a firm. Observe that the demand curve is perfectly elastic. This means
that a firm can sell as many units of the good as it wants to sell at price p.
The marginal revenue (MR) of a firm is defined as the increase in total
revenue for a unit increase in the firm’s output. Consider table 4.1 again. Total
revenue from the sale of 2 boxes of candles is Rs.20. Total revenue from the sale
of 3 boxes of candles is Rs.30.
Changeintotalrevenue 30-20
MarginalRevenue(MR)= = =10
Changeinquantity 3-2
Price Line. The price line shows the relationship
between the market price and a firm’s output level.
The vertical height of the price line is equal to the
market price, p.
Fig. 4.2
Price
Price Line
O
Output
p
Total Revenue curve. The total revenue curve of
a firm shows the relationship between the total
revenue that the firm earns and the output level of
the firm. The slope of the curve, Aq
1
/Oq
1
, is the
market price.
Fig. 4.1
Revenue
TR
O
Output
A
q
1
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Introductory
Microeconomics
Is it a coincidence that this is the same as the price? Actually it is not. Consider
the situation when the firm’s output changes from q
1 
to q
2
. Given the market
price p,
MR = (pq
2 
–pq
1
)/ (q
2 
–q
1
)
      = [p (q
2 
–q
1
)]/ (q
2 
–q
1
)
      = p
Thus, for the perfectly competitive firm, MR=AR=p
In other words, for a price-taking firm, marginal revenue equals the market
price.
Setting the algebra aside, the intuition for this result is quite simple. 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.
4.3 PROFIT MAXIMISATION
A firm produces and sells a certain amount of a good. The firm’s profit, denoted
by p
1
, is defined to be the difference between its total revenue (TR) and its total
cost of production (TC ). In other words
p = TR – TC
Clearly, the gap between TR and TC is the firm’s earnings net of costs.
A firm wishes to maximise its profit. The firm would like to identify the quantity
q
0
 at which its profits are maximum. By definition, then, at any quantity other
than q
0
, the firm’s profits are less than at q
0
. The critical question is: how do we
identify q
0
?
For profits to be maximum, three conditions must hold at q
0
:
1. The price, p, must equal MC
2. Marginal cost must be non-decreasing at q
0
3. For the firm to continue to produce, in the short run, price must be greater
than the average variable cost (p > AVC); in the long run, price must be greater
than the average cost (p > AC).
4.3.1 Condition 1
Profits are the difference between total revenue and total cost. Both total revenue
and total cost increase as output increases. Notice that as long as the change in
total revenue is greater than the change in total cost, profits will continue to
increase. Recall that 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. By the same logic, as long as
marginal revenue is less than marginal cost, profits will fall. It follows that for
profits to be maximum, marginal revenue should equal marginal cost.
In other words, profits are maximum at the level of output (which we have
called q
0
) for which MR = MC
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.
4.3.2 Condition 2
Consider the second condition that must hold when the profit-maximising output
level is positive. Why is it the case that the marginal cost curve cannot slope
1
It is a convention in economics to denote profit with the Greek letter p .
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The Theory of the Firm
under Perfect Competition
downwards at the profit-
maximising output level? To
answer this question, refer once
again to Figure 4.3. Note that at
output levels q
1
 and q
4
, the
market price is equal to the
marginal cost. However, at the
output level q
1
, the marginal
cost curve is downward sloping.
We claim that q
1
 cannot be a
profit-maximising output level.
Why?
Observe that for all output
levels slightly to the left of q
1
,
the market price is lower than
the marginal cost. But, the
argument outlined in  section
4.3.1 immediately implies that
the firm’s profit at an output
level slightly smaller than q
1
exceeds that corresponding to
the output level q
1
. This being the case, q
1
 cannot be a profit-maximising
output level.
4.3.3 Condition 3
Consider the third condition that
must hold when the profit-
maximising output level is
positive. Notice that the third
condition has two parts: one part
applies in the short run while the
other applies in the long run.
Case 1: Price must be greater
than or equal to AVC in the
short run
We will show that the
statement of Case 1 (see above) is
true by arguing that a profit-
maximising firm, in the short run,
will not produce at an output level
wherein the market price is lower
than the AVC.
Let us turn to Figure 4.4.
Observe that at the output level q
1
,
the market price p is lower than
the AVC. We claim that q
1
 cannot be a profit-maximising output level. Why?
Notice that the firm’s total revenue at q
1
 is as follows
      TR = Price × Quantity
= Vertical height Op × width Oq
1
= The area of rectangle OpAq
1
Price-AVC Relationship with Profit
Maximisation (Short Run).  The figure is used to
demonstrate that a profit-maximising firm produces
zero output in the short run when the market price,
p, is less than the minimum of its average variable
cost (AVC). If the firm’s output level is q
1
, the firm’s
total variable cost exceeds its revenue by an amount
equal to the area of rectangle pEBA.
Fig. 4.4
Price,
costs
O
Output
q
1
A
E
SMC
B
p
SAC
AVC
Conditions 1 and 2 for profit maximisation.
The figure is used to demonstrate that when the
market price is p, the output level of a profit-
maximising firm cannot be q
1
 (marginal cost curve,
MC, is downward sloping), q
2
 and q
3 
(market price
exceeds marginal cost), or q
5
 and q
6 
(marginal cost
exceeds market price).
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