Key Notes: The Theory of the Firm under Perfect Competition | Economics for Grade 11 PDF Download

Introduction

This chapter gives the definition of market and its structure, forms of market mainly perfect competition and its features and related concepts (the remaining forms of market being studied in Chapter-12) and short run equilibrium condition under it.

• Market refers to a region where the buyers and sellers of a commodity come in contact with each other to effect the transactions of purchase and sale of the commodity.
• Market structure refers to number of firms and types of firms operating in the industry.
• Three basis on which different market are defined:
  (a) Nature of commodity: If homogeneous goods are produced in a market, it is sold at a constant price. If commodity produce is of heterogeneous or differentiated in nature, it may be sold at different prices. If commodity has no close substitute, the seller can charge higher price from the buyer.
  (b) Number of buyer and sellers: If there are large number of buyers and sellers, then buyers and sellers are not in a position to influence the price of the commodity. If, there is a single seller of a commodity, then the seller has control over a price.
  (c) Entry and exit of a firm: If there is a free entry and exit of a firm, then the price will be stable in the long run. It is so because then the new firm enter the industry induced by large profit, then abnormal profit will be wiped out and if inefficient firms incurring losses are free to leave the industry. In short due to free entry and exit, firm earns normal profit. If there is difficult entry of a new firm (because of patent rights), then a firm can influence the price as it has no fear of competition.
• Main forms of market are:
  (a) Perfect competition
  (b) Imperfect competition.
  (i) Monopoly
  (ii) Monopolistic competition (iii) Oligopoly.
• Perfect Competition refers to a market situation in which buyers and sellers operate freely and a commodity sells at a uniform Constant) price.

Features of Perfect Competition:

Large number of sellers and buyers:

• The words ‘large number’ simply states that the number of sellers is large enough to render a single seller’s share in total market supply of the product is insignificant.
• Insignificant share means that if only one individual firm reduces or raises its own supply, the prevailing market price remains unaffected.
• The prevailing market price is the one which was set through the intersection of market demand and market supply forces, for which all the sellers and all the buyers together are responsible.
• One single seller has no option but to sell what it produces at this market determined price. This position of an individual firm in the total market is referred to as price taker. This is a unique feature of a perfectly competitive market.

(ii) Large number of buyers

• The words ‘large number’ simply states that the number of buyers is large enough, that an individual buyer’s share in total market demand is insignificant, the buyers cannot influence the market price on his own by changing his demand.
• This makes a single buyer also a price taker. To sum up, the feature “large number” indicates ineffectiveness of a single seller or a single buyer in influencing the prevailing market price on its own, rendering him simply a price taker.

Homogeneous Products

(i) Product sold in the market are homogeneous, i.e., they are identical in all respects like quality, colour, size, weight, design, etc.
(ii) The products sold by different firms in the market are equal in the eyes of the buyers.
(iii) Since, a buyer cannot distinguish between the product of one firm and that of another, he becomes indifferent as to the firms from which he buys.
(iv) The implication of this feature is that since the buyers treat the products as identical they are not ready to pay a different price for the product of any one firm. They will pay the same price for the products of all the firms in the industry. On the other hand, any attempt by a firm to sell its product at a higher price will fail. To sum up, the “homogenous products” feature ensures a uniform price for the products of all the firms in the industry.

Free entry and exit of firms

(i) Buyers and sellers are free to enter or leave the market at any time they like. New firms induced by large profits can enter the industry whereas losses make inefficient firms to leave the industry.
(ii) The freedom of entry and exit of firms has an important implication. This ensures that no firm can earn above normal profit in the long run. Each firm earns just the normal profit, i.e., minimum necessary to carry on business.
(iii) Suppose the existing firms are earning above normal profits, i.e. positive economic profits. Attracted by the positive profits, the new firms enter the industry. The industry’s output, i.e. market supply, goes up. The prices come down. New firms continue to enter and the prices continue to fall till economic profits are reduced to zero.
(iv) Now suppose the existing firms are incurring losses. The firms start leaving. The industry’s output starts falling, prices going up, and all this continues till losses are wiped out. The remaining firms in the industry then once again earn just the normal profits.
(v) Only zero economic profit in the long run is the basic outcome of a perfectly competitive market.

Perfect Knowledge about the market:

(i) Perfect Knowledge means both buyers and sellers are fully informed about the market.
(ii) The firms have all the knowledge about the product market and the input markets. Buyers also have perfect knowledge about the product market.
(iii) The implication of perfect knowledge about the product market is that any attempt by any firm to charge a price higher than the prevailing uniform price will fail. The buyers will not pay because they have perfect knowledge. A uniform price prevails in the market.
(iv) Regarding the knowledge about the input markets the implicit assumption is that each firm has an equal access to the technology and the inputs used in the technology.
(v) No firm has any cost advantage. Cost structure of each firm is the same. All the firms have a uniform cost structure.
(vi) Since there is uniform price and uniform cost in case of all firms, and since profit equals revenue less cost, all the firms earn uniform profits.

Perfect mobility:

(i) There is perfect mobility in the market both for goods and factors of production.
(ii) There should be no restriction on their movement. Goods can be sold at any place.
(iii) Similarly, factors of production can freely move from one place to another or from one occupation to another.
(iv) Absence of transportation and selling cost.
(v) In perfect competition, it is assumed that there is no transport cost for consumers who may buy from any firm and also there is no selling cost.
(vi) This insures existence of a single uniform price of the product.

Shutdown point

Shutdown point is a point where a firm is indifferent between whether to produce or shutdown. In other words, it is a situation when a firm is able to cover its variable costs only.
The condition of shutdown point is:
Price = Minimum of SAVC (Short run average variable cost)
Multiply by output
Price x output = SAVC x output
TR = TVC

Words that Matter

• Market: It refers to a region where the buyers and sellers of a commodity come in contact with each other to effect the transactions of purchase and sale of the commodity.
• Market structure: It refers to number of firms and types of firms operating in the industry.
• Perfect Competition: It refers to a market situation in which buyers and sellers operate freely and a commodity sells at a uniform (Constant) price.
• Homogeneous Products: Product sold in the market are homogeneous, i.e., they are identical in all respects like quality, colour, size, weight, design, etc.
• Break-even point: It is the level of output at which total cost of production (Fixed Cost + Variable Cost) per unit just equals to Total Revenue.
• Shutdown point: It is a point where a firm is indifferent between whether to produce or shutdown. In other words, it is to a situation when a firm is able to cover its variable costs only.