The Theory of the Firm under Perfect Competition

The Theory of the Firm under Perfect Competition explains how a firm decides how much to produce when it is one of a very large number of sellers of a homogeneous product and must accept the market price. In this chapter you will study the features of perfect competition: many buyers and sellers, identical products, free entry and exit and perfect information. You will learn about total revenue, average revenue and marginal revenue, and why the price line is also the AR and MR curve of a price-taking firm. You will derive the conditions for profit maximisation: price equals marginal cost, MC is non-decreasing at that output, and price is at least equal to minimum AVC in the short run and minimum AC in the long run. From these you will derive the supply curve of a firm, identify the shut down point and the break-even point, and derive market supply. The chapter also explains price elasticity of supply, its measurement, and the factors that shift a firm's supply curve, such as technology, input prices and unit taxes.

Detailed Worksheet: The Theory of the Firm under Perfect Competition Section A - Definitions (10 marks) 1. State any four features of perfect competition. (2 marks) 2. Why is a firm under perfect competition a price taker? (2 marks) 3. Define the shut down point of a firm in the short run. (2 marks) 4. What is meant by normal profit? What is the break-even point? (2 marks) 5. Define price elasticity of supply. Write its formula. (2 marks) Section B - Calculations and Applications (15 marks) 6. A firm sells its product at a market price of Rs 10. Calculate TR, AR and MR for outputs of 1 to 5 units. What is the relationship between AR, MR and price? (3 marks) 7. A firm faces a market price of Rs 20. Its TFC is Rs 30 and the MC of the 1st to 6th units is Rs 25, 18, 15, 20, 26 and 32. Find the profit-maximising output, the TR, TC and profit at that output, and state whether the firm should continue production in the short run. (3 marks) 8. When the price of a good rises from Rs 10 to Rs 12, its quantity supplied rises from 200 to 260 units. Calculate the price elasticity of supply and state whether supply is elastic or inelastic. (3 marks) 9. The supply function of a firm is q = 2p - 10. Calculate the price elasticity of supply at p = 10. Explain the result using the point where the supply curve meets the price axis. (3 marks) 10. Two firms have supply functions S1: q = p - 5 for p >= 5 (zero otherwise) and S2: q = 2p - 30 for p >= 15 (zero otherwise). Calculate market supply at p = 10 and at p = 20. (3 marks) Section C - Diagrams (10 marks) 11. Draw a diagram showing the short run supply curve of a firm as the part of the SMC curve above the minimum AVC. Mark the shut down point. (4 marks) 12. Draw the TR curve of a price-taking firm and the AR = MR line. Explain why TR is a straight line through the origin. (3 marks) 13. Draw a diagram showing the long run equilibrium of a firm where price equals minimum LRAC, marking normal profit. (3 marks) Section D - Analysis and Higher-order Thinking (15 marks) 14. Explain the three conditions for profit maximisation of a perfectly competitive firm. Explain with a diagram why the firm does not produce where MC = price on the falling part of the MC curve. (5 marks) 15. Explain how each of the following shifts the supply curve of a firm: (i) a technological improvement, (ii) a rise in input prices, (iii) imposition of a unit tax and (iv) an increase in the number of firms (for market supply). Use diagrams for any two. (5 marks) 16. A firm is making losses but still continues production. Analyse when this is rational in the short run and why it is not possible in the long run. Explain the difference between the short run and long run supply curves of a firm. (5 marks) Instructions: Time allowed 2 hours. Attempt all sections. Show schedules and formulae in calculations. Draw neat, labelled diagrams.