The Theory of the Firm under Perfect Competition

A price-taking firm: total, average and marginal revenue, profit maximisation at p = MC, the shut down and break-even points, supply curves and price elasticity of supply.

Key ideas

• Perfect competition has many buyers and sellers, an identical product, free entry and exit and perfect information, so each firm is a price taker.
• A competitive firm faces a horizontal demand curve at the market price, so AR = MR = price and TR is a straight line from the origin.
• Profit is greatest where price equals MC on the rising part of the MC curve, as long as price is at least minimum AVC.
• In the short run a firm keeps producing at a loss if price covers AVC; below minimum AVC it shuts down.
• At the break-even point price equals minimum AC: TR = TC and the firm earns only normal profit.
• The firm’s short-run supply curve is the rising part of MC above minimum AVC; better technology shifts it right, while a unit tax or dearer inputs shift it left.
• Market supply is the horizontal sum of firms’ supply curves.

Remember

Watch out

• Choosing output on the falling part of MC where p = MC (it must be the rising part).
• Shutting down whenever there is a loss: in the short run the firm stays open if price covers AVC.
• Mixing up the shut down point (min AVC) and the break-even point (min AC).

Worked example