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Book No. – 3 (Economics)
Book Name – Principles of Microeconomics (HL Ahuja)
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1. MEANING AND CONDITIONS (le.. ASSUMPTIONS) OF PERFECT COMPETITION
1.1. The Demand Curve of a Product Facing a Perfectly Competitive Firm
1.2. Meaning of Firm’s Equilibrium
1.3. Firm’s Equilibrium Under Perfect Competition: MR-MCApproach
1.4. Second Order Condition for Equilibrium ofthe Firm
2. SHORT-RUN EQUILIBRIUM OF THE FIRM UNDER PERFECT COMPETITION
2.1. Minimising Losses
2.2. Deciding to Shut Down
3. LONG-RUN EQUILIBRIUM OF THE FIRM UNDER PERFECT COMPETITION
3.1. Why Do Competitive Firms Stay in Business if They Make Zero Economic Profits?
4. SHORT-RUN SUPPLY CURVE OF THE PERFECTLY COMPETITIVE FIRM
5. SHORT-RUN SUPPLY CURVE OF THE COMPETITIVE INDUSTRY
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Equilibrium of the Firm under Perfect Competition
Chapter – 23
MEANING AND CONDITIONS (i.e., ASSUMPTIONS) OF PERFECT COMPETITION
Perfect competition is characterized by the following conditions:
- There are a large number of firms producing and selling a product.
- The product of all firms is homogeneous.
- Both sellers and buyers have perfect information about the prevailing price in the market.
- Entry into and exit from the industry is free for the firms.
- The first condition, a large number of firms, ensures that no single firm can influence the market price. The output of an individual firm is a small fraction of the total market output. As a result, each firm is a price-taker and adjusts output to maximize profits, instead of setting the price.
- The second condition, homogeneous products, means all firms produce identical goods, which are perfect substitutes. Buyers do not distinguish between the products, leading to no price control for individual firms.
- Cross elasticity between the products is infinite under perfect competition because the products are indistinguishable. If products are differentiated in any way (e.g., branding, patents), the price control by firms would exist.
- The homogeneity of the product is judged from the buyer’s perspective. If buyers perceive any difference, the product cannot be considered homogeneous, and sellers would have control over prices.
- Under perfect competition, there is perfect information about prices. Buyers know the prevailing market price, and sellers are aware of it as well. Sellers cannot charge more than the prevailing price because buyers will simply shift to other sellers.
- Free entry and exit into the industry allow firms to enter when there are super-normal profits in the short run and exit when firms are incurring losses. This ensures long-run equilibrium where firms earn normal profits.
- In the long-run equilibrium under perfect competition, new firms enter if existing firms are making super-normal profits, which drives prices down. On the other hand, firms that incur losses exit, leading to a rise in prices for the remaining firms. This process ensures that all firms in the industry earn at least normal profits in the long run.
The Demand Curve of a Product Facing a Perfectly Competitive Firm
- The first three conditions of perfect competition ensure a single price in the market.
- The demand curve or average revenue curve faced by an individual firm under perfect competition is perfectly elastic at the ruling price.
- A perfectly elastic demand curve means the firm cannot influence the price and can sell any quantity at the ruling price.
- If the firm raises its price above the ruling price, it will lose all customers to competitors.
- Since the firm can sell any amount at the prevailing price, it has no incentive to lower the price.
- The firm accepts the ruling price and adjusts its output to maximize profits.
- When the market price is established, the firm takes it as a given and adjusts output accordingly.
- In Fig. 23.1, the demand curve (DD) and supply curve (SS) intersect at point E, determining price OP.
- The firm faces a horizontal average-marginal revenue curve at price OP.
- If demand increases, price rises to OP’, and the firm’s average-marginal revenue curve shifts to OP’.
- If demand decreases and price falls to OP”, the average-marginal revenue curve shifts to OP”.
- The fourth condition, free entry and exit, ensures that the firm earns only normal profits in the long run.
- Super-normal profits disappear due to the entry of new firms, while losses are eliminated as firms exit the industry.