Theory of the Firm under Perfect Competition

About this unit

This unit studies a market with many small firms selling an identical product, where no single firm can influence the price. It explains how such a price-taking firm decides how much to produce, when it should stop producing, and how the supply curve of a firm and of the whole market is built from cost curves. It ends with the price elasticity of supply.

Key ideas

• Features: many buyers and sellers, homogeneous product, free entry and exit, perfect information.
• A competitive firm is a price taker facing a horizontal demand curve (AR = MR = P).
• Profit maximisation: P = MC with MC rising; P ≥ AVC in the short run and P ≥ AC in the long run.
• Shutdown point (minimum AVC) and break-even point (minimum AC).
• The firm's supply curve is the rising part of its MC curve above minimum AVC.
• Determinants of supply and the difference between movement along and shift of the supply curve.
• Price elasticity of supply.

How to prepare

Practise the three profit-maximisation conditions with diagrams showing profit and loss. Be ready to decide whether a firm should continue or shut down using AVC. Learn the geometric rule for elasticity of a straight-line supply curve.