Theory of Firm Under Perfect Condition

Theory of Firm Under Perfect Competition

In this article, find all you need to know about theory of a firm under perfect competition.

What is Perfect Competition?

Perfect Competition can be defined as a market structure where a large number of buyers and sellers engage in the buying and selling of homogeneous products (the outputs of all the sellers are similar to each other) which are uniformly priced at prices prevailing in the market. No individual seller is capable of influencing the price of an existing product in the market. In this article, find all you need to know about theory of a firm under perfect competition.

Ideally, perfect competition is a hypothetical situation which cannot possibly exist in a market. However, perfect competition is used as a base to compare with other forms of market structure.

What are the features of a Perfectly Competitive Market?

i) A large number of buyers and sellers:

In perfect competition, the buyers and sellers are numerous in nature. Therefore, an individual customer cannot influence the price of a commodity, as he is too small in comparison to the entire market. Similarly, a single seller cannot influence the levels of produce, as he too is small in relation to the large number of sellers operating in the market. Due to the large number of sellers in the market, there exists a perfect and free competition. A firm acts as a price taker, since the price is determined by the ‘invisible hand, i.e. by the demand and supply parameters of goods and services. Thus, it can be concluded that under perfectly competitive market, an individual firm is a price taker and not a price maker.

ii) Homogenous products:

Each competing firm offers the homogeneous product, such that no individual has a preference for a particular seller over the others. This implies that the products of every firm are perfect substitutes of every other firm in the market, in terms of quantity, quality, colour, size, features, etc. This indicates that the buyers are indifferent towards the firms that offer these outputs. Due to the homogenous nature of products, uniformity in prices is guaranteed.

iii) Free exit and entry of firms:

Under perfect competition, the firms are free to enter or exit the industry in the long run. This simply means that if a firm suffers from a huge loss due to the intense competition in the industry, it is free to leave the industry. The same applies for entry into the industry. Thus, there is no restriction on the mobility of sellers. However, in the short run, a few factors hinder the free entry and exit of these firms. This ensures that all the firms in the long-run earn normal profit or zero economic profit which helps in determining the opportunity cost to the firms, and deciding upon whether  to continue production or to shut down. Hence, in case of abnormal profits, new firms will enter the market and abnormal losses will cause a few existing firms to exit the market.

iv) Perfect knowledge among buyers and sellers:

Both buyers and sellers have full knowledge of the market conditions, such as the price of a product at different places. The sellers are also aware of the prices at which the buyers demand the product. Hence, if any individual firm charges a higher (or lower) price for a homogeneous product, the buyers are bound to shift their purchase to other firms (or shift their purchase from the other firms to the firm selling at lower price).

v) No transport costs:

Absence of transportation costs incurred in carrying the goods from one market to another, imply that all firms have equal access to the market. This is an important condition since the homogeneous product must be priced the same across the market and if the transportation cost is added to it, then its prices may differ.

vi) Perfect mobility of factors of production:

There is existence of perfect mobility of factors of production, geographically and occupationally. This implies that the factors of production can move from one place to other and can move from one job to another, easily.

vii) No promotional and selling costs and no restrictions:

There are no advertisements and promotional costs incurred by the firms for the sale of their output. The selling costs under perfectly competitive market are zero. Also, there is no restriction is imposed on either party to participate in a transaction. The prices too are liable to change freely as per the demand-supply conditions.

What is a Price Line?

“A budget line or price line represents the various combinations of two goods which can be purchased with a given money income and assumed prices of goods”. It is the graphical representation of the relationship between output and price, with the x-axis denoting the output and the y-axis denoting the price. For a perfectly competitive firm, price line and demand curve are the same. The price line is horizontal because the firm is a price taker. The price of the firm’s output is the same, regardless of the quantity that the firm decides to produce.

What is Revenue?

Revenue, in simple terms, means the receipts of a firm upon sale of its output. If the market price of a unit of good is p and the quantity of goods sold is q, the revenue hence earned is p x q.

What is Total Revenue?

Total revenue can be defined as the total proceeds from sales of a producer, received by selling corresponding levels of output. In other words, it is defined as price into the quantity of output sold.

Total Revenue = Price x Quantity of output sold

In a perfectly competitive market, the market price is given (fixed), i.e., a firm act as a price taker and cannot influence the price. Hence, a particular firm can influence its Total Revenue by changing the quantity of output sold.

What is Average Revenue?

The revenue earned per unit of output sold is called the average revenue. It can be calculated as follows:


What is Marginal Revenue?

The change observed in total revenue due to sale of one more unit or one less unit of output, is called the marginal revenue.

MR = TRn – TRn-1


MR =    Δ TR/Δ Q

Shape of TR curve under Perfect Competition:

The total revenue curve for a firm in a perfectly competitive market is an upward sloping because the price or AR remains constant and MR is also equal to AR. Thus, TR can only be influenced by changing the amount of output sold, as the price remains constant. The increase in TR is in the same proportion as the increase in the output sold.

The curve passes through the origin, which means that irrespective of what the price level is, if the output sold is zero, TR will also be zero.

Shape of AR and MR curves under Perfect Competition:

In a perfect competitive firm, marginal revenue is equal to the market price per unit of output. Therefore, its AR and MR curves are the same and parallel to the X-axis.

What is Break Even Point?

Break even for a firm occurs when it is able to cover its all costs of production. Therefore, break- even point is defined as a situation when total revenue is equal to total costs or Average Revenue is equal to Average costs. Under the situation of a perfect competition, the firm earns only normal profits.

What is Shut down Point?

A business needs to make at least normal profit in the long run to justify remaining in an industry but in the short run, a firm shall continue production as long as the price per unit of output is greater than or equal to its average variable cost. This is called the shutdown price in a competitive market. The shutdown point occurs when firm is only able to cover its variable costs, thus increasing the loss of fixed cost of production. Hence, it is the situation when TR= TVC or AR= AVC.

Producer Equilibrium or Profit Maximisation

A producer is said to be in equilibrium, when the firm either maximizes its profits or minimizes its losses. The following three conditions must hold if a profit maximizing firm produces positive level of output (say equilibrium output Q*) in a competitive market:

  1. i) MR must be equal to MC at Q*.
  2. ii) MC should be upward sloping or rising at Q*, or MC should cut MR from below.

iii) In the short run, price must be greater than or equal to AVC. i.e. at Q*. In the long run, price must be greater than or equal to LAC.

Meaning of Supply

Supply means the quantity of commodity that firms are able and willing to sell in the market in a given period of time and at a given price.

Supply Schedule

Supply schedule is a tabular statement that illustrates that relationship between the price of a good and the quantity supplied.

Short Run Supply Curve

The short run supply curve of perfect competitive firm is the summation of the upward sloping portion of SMC (above the minimum point of SAVC), when price  min SAVC, and vertical portion of price-axis, when price < min SAVC.

Stage 1

When the price is greater than or equal to minimum of SAVC, i.e., P min SAVC.

At the market price OP, the three following conditions for equilibrium are fulfilled:

  • MC = MR
  • MC is upward sloping
  • Price exceeds the minimum of SAVC

At this market price the firm is producing profit maximizing output Oq1. In this case, the supply curve of the firm is regarded as the upward sloping part of SMC (above the minimum point of SAVC), i.e. SS. When the price is greater than or equal to minimum of SAVC, the supply curve is indicated by SS.

Stage 2

When the price is less than the minimum of SAVC

Let us suppose that the firm is facing price OP1 that is lesser than the minimum of SAVC. At this price, the firm cannot continue production as it cannot even cover up its variable costs and thereby incurs losses, which implies that the firm would produce nothing. Thus, it will incur loss that will be equivalent to its fixed costs. It will be lesser compared to the losses associated with producing any positive output level. Thus, the firm will not produce anything at this price and thereby the quantity supplied will be zero. The firm’s supply curve is indicated by the darkened vertical line S1S1.

Therefore, the short run supply curve of perfect competitive firm is (SS +S1S1).

Determinants of Supply Curve

  • Technological Progress

If the technology available to the firm is bettered, increased amount of output can be produced by the firm using the same levels of capital and labour. Due to such innovations or technological advancements, the firm will experience lower cost of production, which will lead to rightward downward shift of the MC curve. This will further lead to rightward shift of the firm’s supply curve.

  •   Input Price

An increase in the price of an input increases the cost of production, which in turn increases the marginal cost of the firm. Hence, the MC curve will shift upward to the left and the supply curve will also shift upward left. Therefore, an increase in the input price negatively affects the supply of the firm.

  • Unit Tax

Unit tax is the tax imposed on per unit of the output sold. Due to the imposition of unit tax, the cost of production per unit of output increases, this consequently increases the marginal cost. Hence, the MC curve will shift leftward upward and as the supply curve is a portion of MC, therefore, the supply curve will also shift leftward upward.

Elasticity of Supply

This refers to the measure of the degree of responsiveness of quantity supplied to changes in the commodity’s own prices. Elasticity of supply is measured as the ratio of proportionate change in the quantity supplied to the proportionate change in price.

Measurement of Elasticity of Supply

Percentage method:

E =% Change in quantity supplied / % Change in price or ΔQ/ΔP = P/Q

Here, P = Actual Price, Q= Actual Quantity ΔP = Change in Price, ΔQ = Change in Quantity

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