The Theories of the Firm
This document is produced by Learning and Teaching Scotland as part of the National Qualifications support programme for Economics.
First published 2002
Electronic version 2002
© Learning and Teaching Scotland 2002
This publication may be reproduced in whole or in part for educational purposes by educational establishments in Scotland provided that no profit accrues at any stage.
ISBN 1 85955 929 8
Section 1:The theory of perfect competition3
Section 2:The theory of monopoly9
Section 3:The theory of monopolistic competition and
Section 4:Resource allocation/externalities19
Section 5:Suggested solutions23
There are basically two types of market situation:
(a)Perfect competition – in this market, firms have no influence; they are price takers. (b)Imperfect competition – this market includes monopoly, oligopoly and monopolistic competition; firms are price makers and can influence the market place.
Every firm must obey three rules in order to survive:
•To maximise profits, firms will produce at that output where MC=MR and at the same time MC must be rising. •A firm will continue to produce in the short run as long as it can cover its variable costs. •In the long run a firm must cover its total costs.
In order to build a model against which we can compare other market situations, certain characteristics have to be assumed:
•There are a large number of buyers and sellers in the market. •Buyers and sellers have perfect knowledge of goods and prices in the market. •All firms produce a homogeneous product. Products are identical. •There is freedom of exit and entry to the industry.
•There is perfect mobility of the factors of production.
In the real world it is almost impossible for all of these conditions to exist at the same time. Foreign exchange and agriculture are markets that have some of the above characteristics: currency is a homogeneous product and in agriculture there are a large number of farmers supplying the market without influencing the price. Can you identify other types of markets that are almost perfectly competitive?
The demand curve
No one firm can alter output enough to influence price. Therefore each firm faces a perfectly elastic demand curve. Each firm sells at a given market price and this price coincides with the firm’s AR and MR.
The firm can sell as much as it wants at this price, however if it charged above this price, demand would fall to zero.
The supply curve
The short run supply curve of the firm in perfect competition will be that part of its marginal cost curve that lies above its average variable cost curve.
MC is the lowest price at which a firm would sell an extra unit, and when we remember the second rule above that the firm must obey to maximise profit, we have correctly identified the firm’s short run supply curve.
The equilibrium of the firm
The firm is in equilibrium when MR=MC. This is where profits are maximised or losses minimised. For the perfectly competitive firm the only decision to be made is how much to produce to maximise profits. Firms cannot influence price because their output is a very small part of market output.
Equilibrium of the Firm – Perfect Competition
In the short run, firms earning supernormal profits will attract other firms into the market looking for higher than normal rewards. Remember that normal profit is just enough to keep the entrepreneur in business.
Perfect Competition – Short Run
In the long run, as new firms enter the industry,...