Chapter 4: The Theory of the Firm under Perfect Competition

4.1 Perfect Competition: Defining Features

Perfect Competition: A market structure characterized by:

  1. Large number of buyers and sellers
  2. Homogeneous products (identical goods)
  3. Free entry and exit of firms
  4. Perfect information
  5. Price-taking behavior

Price-taking behavior: Firms accept the market price as given and cannot influence it.

4.2 Revenue

Total Revenue (TR): Total money received from selling output

Formula: TR = p × q

Average Revenue (AR): Revenue per unit sold

Formula: AR = TR/q = p

Marginal Revenue (MR): Change in total revenue from selling one more unit

Formula: MR = ΔTR/Δq = p

In perfect competition: AR = MR = p

Revenue Curves

TR Curve: Straight line through origin with slope = p

AR/MR Curve: Horizontal line at market price (perfectly elastic demand)

Total Revenue Curve

[Upward sloping straight line from origin]

Price Line (AR/MR Curve)

[Horizontal line at market price p]

4.3 Profit Maximization

Profit (π): Difference between total revenue and total cost

Formula: π = TR - TC

Profit Maximization Conditions

Short Run:

  1. p = SMC (Price equals short run marginal cost)
  2. SMC must be non-decreasing at equilibrium output
  3. p ≥ AVC (Price ≥ average variable cost)

Long Run:

  1. p = LRMC (Price equals long run marginal cost)
  2. LRMC must be non-decreasing at equilibrium output
  3. p ≥ LRAC (Price ≥ long run average cost)

Profit Maximization Graph

[Graph showing MC, AC curves with profit rectangle]

4.4 Supply Curve of a Firm

4.4.1 Short Run Supply Curve

The rising portion of the SMC curve above minimum AVC

Short Run Supply Curve

[Graph showing SMC with bold portion above min AVC]

4.4.2 Long Run Supply Curve

The rising portion of the LRMC curve above minimum LRAC

Long Run Supply Curve

[Graph showing LRMC with bold portion above min LRAC]

4.4.3 Shut Down Point

Short Run: Minimum point of AVC curve

Long Run: Minimum point of LRAC curve

4.4.4 Normal Profit and Break-even Point

Normal Profit: Minimum profit needed to keep firm in business (included in costs)

Super-normal Profit: Profit above normal profit

Break-even Point: Where firm earns only normal profit (p = min AC)

4.5 Determinants of a Firm's Supply Curve

4.5.1 Technological Progress

Shifts supply curve to the right (more output at each price)

4.5.2 Input Prices

Increase in input prices shifts supply curve to the left (less output at each price)

Impact of Unit Tax

A tax per unit sold shifts supply curve left by amount of tax

Effect of Unit Tax on Supply

[Graph showing parallel leftward shift of supply curve]

4.6 Market Supply Curve

Horizontal summation of individual firms' supply curves

Market Supply Curve Construction

[Graph showing summation of two firms' supply curves]

Factors affecting market supply:

4.7 Price Elasticity of Supply

Price Elasticity of Supply (es): Responsiveness of quantity supplied to price changes

Formula: es = (%ΔQs) / (%ΔP)

Calculating elasticity:

es = (ΔQ/Q) / (ΔP/P) = (ΔQ/ΔP) × (P/Q)

Elasticity for Straight-line Supply Curves

  1. Supply curve intersecting price axis: es > 1
  2. Supply curve through origin: es = 1
  3. Supply curve intersecting quantity axis: es < 1

Price Elasticity of Supply Cases

[Three panels showing different supply curve intersections]

Chapter Summary