The Theory of the Firm under Perfect Competition
The Theory of the Firm under Perfect Competition tests price-taking, revenue curves, short-run shut-down and long-run normal profit.
Firm under perfect competition
Features: many buyers and sellers, homogeneous product, free entry and exit, perfect information, no transport costs. The firm is a price taker: P=AR=MR, a horizontal revenue line. Total revenue TR=P×Q; profit=TR−TC. Short-run equilibrium is at P=MC with MC rising; if P<AVC, the firm shuts down; if AVC<P<AC, it produces at a loss but covers variable costs. Long-run equilibrium is at P=MC=minimum AC, with normal profit only.
The firm’s short-run supply curve is the rising part of MC above AVC. Market supply is horizontal summation of individual supplies. Profit maximisation can also be shown by comparing MR and MC: expand while MR>MC; contract when MC>MR.
Worked example
A competitive firm sells at ₹20. Its MC schedule is ₹18 at Q=9 and ₹22 at Q=10. Output 9 gives MR>MC, so expand; output 10 gives MC>MR, so contract. Equilibrium is at Q=9, where MC is close to MR=₹20. If AVC at Q=9 is ₹23, the firm shuts down because price does not cover variable cost, even though it may cover part of fixed cost.
Traps
P=MC is not the profit-maximising rule for a monopoly; there MR=MC. Do not say a firm always shuts down when it makes a loss: shut-down depends on P versus AVC. In long-run equilibrium firms earn normal profit, not necessarily zero accounting profit. The supply curve does not include the MC segment below AVC.