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The Theory of the Firm under Perfect Competition – Class 12 Economics notes, important questions and MCQs

NCERT Class 12 Economics, chapter 4. Notes, key terms, important questions with answers and MCQs.

Chapter overview

Perfect competition is a market with many buyers and sellers, a homogeneous product, free entry and exit, and perfect information. Each firm is a price taker, so its average and marginal revenue equal the market price. A firm maximises profit where price equals marginal cost and marginal cost is rising. The firm's supply curve is the rising part of its marginal cost curve above minimum average variable cost.

Features and revenue

Many buyers and sellers, so no single firm can influence the price.
Homogeneous products, free entry and exit, perfect knowledge and perfect mobility of factors.
Total revenue (TR) = price × quantity; for a price-taking firm, average revenue (AR) = marginal revenue (MR) = price, so the demand curve facing the firm is horizontal.

Profit maximisation

Conditions: price = marginal cost (P = MC), MC is non-decreasing at that output, and in the short run P ≥ AVC (in the long run P ≥ minimum AC).
If price falls below minimum AVC, the firm shuts down in the short run; minimum AVC is the shutdown point.
In the long run, free entry and exit make price equal to minimum average cost, so firms earn only normal profit.

Supply curve and elasticity

The short-run supply curve of a firm is the part of the SMC curve above minimum AVC; the long-run supply curve is the part of LRMC above minimum LRAC.
Supply increases with better technology, lower input prices and unit subsidies; it decreases with higher input prices and unit taxes.
Price elasticity of supply = percentage change in quantity supplied ÷ percentage change in price.

Key terms

Perfect competition: a market with many buyers and sellers, a homogeneous product and free entry and exit
Price taker: a firm that cannot influence the market price and must accept it
Marginal revenue: the change in total revenue from selling one more unit
Shutdown point: the minimum point of the AVC curve, below which a firm stops production in the short run
Normal profit: the minimum profit needed to keep a firm in the industry, included in cost

Important questions with answers

Why is a firm under perfect competition a price taker?2 marks

Under perfect competition there are a very large number of firms selling a homogeneous product, and each firm's output is a tiny fraction of total supply. So no single firm can influence the market price; it must accept the price determined by market demand and supply and can sell any quantity at that price.

State the conditions of profit maximisation for a perfectly competitive firm.3 marks

A perfectly competitive firm maximises profit where price equals marginal cost (P = MC); marginal cost must be non-decreasing at that level of output; and in the short run price must be at least equal to average variable cost, while in the long run price must be at least equal to average cost.

Explain how a firm under perfect competition decides its output, and derive its short-run supply curve.5 marks

A perfectly competitive firm is a price taker, so its average revenue and marginal revenue are equal to the market price and its demand curve is a horizontal line at that price. The firm chooses the output that maximises profit, that is, total revenue minus total cost. Profit is maximum where marginal revenue equals marginal cost; since MR equals price, the condition is P = MC. Further, MC must be rising at that point, because if MC were falling, producing more would increase profit. In the short run, the firm must also cover its variable costs, so price must be at least equal to average variable cost; if price falls below minimum AVC, the firm minimises losses by shutting down, losing only its fixed costs. Therefore, at each market price above minimum AVC, the firm produces the output where P = SMC on the rising part of the SMC curve. Joining these price-output combinations gives the firm's short-run supply curve, which is the rising part of the SMC curve above the minimum point of the AVC curve. Below this shutdown point, the firm supplies nothing. In the long run, free entry and exit make price equal to minimum average cost, and firms earn only normal profit.

Quick revision

Many sellers, homogeneous product, free entry, perfect information.
AR = MR = P (horizontal demand).
Equilibrium: P = MC, MC rising, P ≥ AVC.
Long run: P = minimum AC, normal profit.

Exam tips

Write the three profit-maximising conditions as a list in every answer.
Draw the firm's supply curve as the SMC curve above the AVC minimum.

Practice MCQs

Under perfect competition a firm is a
1. price maker
2. price taker
3. monopolist
4. cartel member
Show answer
Answer: (b) price taker. It accepts the market price.
For a perfectly competitive firm, AR equals
1. zero
2. AVC
3. total cost
4. MR and price
Show answer
Answer: (d) MR and price. The demand curve is horizontal.
Products under perfect competition are
1. homogeneous
2. differentiated
3. unique
4. branded only
Show answer
Answer: (a) homogeneous. Units are identical.
A firm maximises profit where
1. P = AVC
2. TR is maximum
3. P = MC with MC rising
4. AC is minimum
Show answer
Answer: (c) P = MC with MC rising. The second-order condition requires rising MC.
In the short run a firm shuts down if price falls below
1. minimum AC
2. minimum AVC
3. MC
4. AFC
Show answer
Answer: (b) minimum AVC. It cannot cover variable costs.
In the long run, perfectly competitive firms earn
1. supernormal profit
2. monopoly profit
3. losses only
4. normal profit
Show answer
Answer: (d) normal profit. Free entry and exit remove extra profit.
The short-run supply curve of a perfectly competitive firm is
1. the AC curve
2. the AFC curve
3. the demand curve
4. the rising part of SMC above minimum AVC
Show answer
Answer: (d) the rising part of SMC above minimum AVC. At each price it produces where P = MC.
A unit tax on production will
1. shift the supply curve to the right
2. make supply perfectly elastic
3. not affect supply
4. shift the supply curve to the left
Show answer
Answer: (d) shift the supply curve to the left. It raises the marginal cost.

All chapters of Class 12 Economics

Written by Kundali IQ from standard, well-established facts to help with revision. This is not an official NCERT publication; always read your textbook too.