NCERT Books Class 12 Microeconomics Chapter 4- The Theory of the firm under Perfect Competition

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Table of Content-
Topics Covered
Starting of the Chapter
Glimpses of the Chapter
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In the previous chapter, we studied concepts related to a firm’s production function and cost curves. The focus of this chapter is different. Here we ask : how does a firm decide how much to produce? Our answer to this question is by no means simple or uncontroversial. We base our answer on a critical, if somewhat unreasonable, assumption about firm behaviour – a firm, we maintain, is a ruthless profit maximiser. So, the amount that a firm produces and sells in the market is that which maximises its profit. Here, we also assume that the firm sells whatever it produces so that ‘output’ and quantity sold are often used interchangebly.

Examine in detail the profit maximisation problem of a firm. Then,0 we derive a firm’s supply curve. The supply curve shows the levels of output that a firm chooses to produce at different market prices. Finally, we study how to aggregate the supply curves of individual firms and obtain the market supply curve.

In order to analyse a firm’s profit maximisation problem, we must first specify the market environment in which the firm functions. In this chapter, we study a market environment called perfect competition. A perfectly competitive market has the following defining features:

The existence of a large number of buyers and sellers means that each individual buyer and seller is very small compared to the size of the market. This means that  no individual buyer or seller can influence the market by their size. Homogenous products further mean that the product of each firm is identical. So a buyer can choose to buy from any firm in the market, and she gets the same product. Free entry and exit mean that it is easy for firms to enter the market, as well as to leave it. This condition is essential for the large numbers of firms to exist. If entry was difficult, or restricted, then the number of firms in the market could be small. Perfect information implies that all buyers and all sellers are completely informed about the price, quality and other relevant details about the product, as well as the market.

These features result in the single most distinguishing characteristic of perfect competition: price taking behaviour. From the viewpoint of a firm, what does price-taking entail? A price-taking firm believes that if it sets a price above the market price, it will be unable to sell any quantity of the good that it produces. On the other hand, should the set price be less than or equal to the market price, the firm can sell as many units of the good as it wants to sell. From the viewpoint of a buyer, what does price-taking entail? A buyer would obviously like to buy the good at the lowest possible price. However, a price-taking buyer believes that if she asks for a price below the market price, no firm will be willing to sell to her. On the other hand, should the price asked be greater than or equal to the market price, the buyer can obtain as many units of the good as she desires to buy.

Price-taking is often thought to be a reasonable assumption when the market has many firms and buyers have perfect information about the price prevailing in the market. Why? Let us start with a situation where each firm in the market charges the same (market) price. Suppose, now, that a certain firm raises its price above the market price. Observe that since all firms produce the same good and all buyers are aware of the market price, the firm in question loses all its buyers. Furthermore, as these buyers switch their purchases to other firms, no “adjustment” problems arise; their demand is readily accommodated when there are so many other firms in the market. Recall, now, that an individual firm’s inability to sell any amount of the good at a price exceeding the market price is precisely what the price-taking assumption stipulates.