7. A perfectly competitive firm can sell its product for a price of 10. The firm's (short run) total cost function is: C(q) = 5 +3q+q². a. On a well-labeled graph, draw a figure illustrating the firm's profit at different levels of output. Show the profit-maximizing level of output on the graph. Write an expression for the firm's profit maximization problem. b. c. Solve the firm's profit maximization problem to determine the optimal level of output. Be sure to check whether or not the firm should shut down. d. Suppose instead that the price of the output falls to 5. Should the firm shut down? Explain. e. Suppose that instead of the cost function given above, the cost function is C(q) = 5 + 3q. The price of the good is 10. What happens if you try to maximize profit in this situation? Explain.
A market with many buyers and sellers in the market is said to be a perfectly competitive market. A market is considered perfectly competitive as the buyers and the sellers have the perfect knowledge of the product and its prices and sellers are offering homogenous goods.
In such a market, there is no legal restriction on the entry or exit of the firm. Any time any firm can enter the market or any time can leave the market.
Examples are the Stock Market, Grain Market, and Raw Gold Market.
- A LARGE NUMBER OF BUYERS AND SELLERS: The “Large Number” indicates the ineffectiveness of a single seller or buyer in influencing the prevailing market price of its own, as each seller or buyer has an insignificant share in market supply or market demand.
Implications: The output sold by each firm is very small compared to the total output of all the firms combined. Thus, by increasing or decreasing the quantity supplied, a seller cannot affect market supply as he sells only a small proportion of the market supply. In this way, the firm does not have the bargaining power and hence is a “price taker”
The price of the commodity is determined by the market forces of demand and supply and each buyer and seller has to accept the same price. Hence uniform price prevails.
2. HOMOGENOUS GOODS: Those goods which are identical with respect to quality, size, design, and color are called homogenous goods. Such products are the perfect substitutes or the perfect standardized products that the buyers do distinguish the product of one firm from that of another. This makes their elasticity of demand infinite.
Implications: A seller cannot afford to charge a high price for the homogenous goods as the buyer had the option to purchase the same product from another seller.
Uniform price prevails for the products of all the firm in the industry, and those who charge higher prices lose their customers.
3. FREE ENTRY AND EXIT: There are no legal restrictions or barriers to the entry and exit of firms. Firms are free to start producing the commodity or to stop production. A firm seeking profit can enter the market, and any firm suffering loss can leave the market.
Implications: The freedom of entry and exit of firms has an important implication. This ensures that no firm can earn above the normal profit in the long run.
- PERFECT KNOWLEDGE: Buyers and sellers are fully aware of the price and other market conditions.
Implications: The firms have all the knowledge about the product market and the input markets, and thus each firm has equal access to the technology and the inputs used in the technology. No firm has the cost advantage. Thus, all the firms earn uniform profits.
- PERFECT MOBILITY OF THE FACTORS: The resources used in the production process like energy, labor, and raw material can move easily in and out of an industry. There are no artificial barriers (like trade unions, license requirements, patent rights, etc.) and the factors can move to an industry that pays the highest remunerations and no natural barrier which may take the form of huge capital expenditure required to start a new firm.
- NO TRANSPORTATION COST: It is assumed that different firms work close to each other in such a way that there is no transportation cost and if any, is part of the cost of production. This is also a necessary price for the price to be uniform.
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