Question

What do you understand by Perfect Competition? Explain its salient features.
OR
Explain the supply curve of a firm in the short period and long period.

Hint:

To find a firm's supply curve, think about its shutdown/exit condition. In the short run, it must cover at least its variable costs (AVC). In the long run, it must cover all its costs (LAC). The supply curve is the MC curve above these minimum points.

Answer 1

Step 1: Meaning of Perfect Competition:
Perfect Competition is a market structure characterized by a very large number of buyers and sellers of a homogeneous (identical) product, where no individual buyer or seller can influence the market price. The market price is determined by the industry's demand and supply forces, and each firm is a "price-taker." It is a theoretical benchmark model of a market.

Step 2: Salient Features of Perfect Competition:
\begin{enumerate} \item Large Number of Buyers and Sellers: There are so many firms and buyers that the actions of any single one have a negligible impact on the market price and output. \item Homogeneous Product: All firms in the industry sell an identical product. There is no difference in terms of quality, design, or branding. This makes the products perfect substitutes for each other. \item Freedom of Entry and Exit: Firms are free to enter the industry if there are super-normal profits and exit the industry if they are incurring losses. This ensures that in the long run, firms earn only normal profits. \item Perfect Knowledge: Both buyers and sellers have complete information about the market prices and the quality of the product. This prevents any firm from charging a different price than the market price. \item Perfect Mobility of Factors of Production: Resources like labor and capital can move freely from one firm to another or from one industry to another without any restrictions. \item No Transport Costs: It is assumed that there are no transport costs, so that a single uniform price prevails throughout the market. \end{enumerate}

Step 3: Final Answer:
Perfect competition is a market with many sellers and buyers, an identical product, and free entry and exit. Its key features lead to a situation where firms are price-takers and earn only normal profits in the long run.
Solution (Supply Curve of a Firm):

Step 1: Understanding the Supply Curve:
A firm's supply curve shows the quantity of output the firm is willing and able to offer for sale at different prices. Under perfect competition, a firm aims to maximize profit by producing at the level where Price (P) = Marginal Cost (MC). Therefore, the firm's MC curve is the basis for its supply curve.

Step 2: Short-Period Supply Curve:
In the short run, a firm has fixed costs and variable costs. The firm will continue to produce as long as the price is greater than or equal to its Average Variable Cost (AVC). If the price falls below AVC, it will shut down to minimize losses. Therefore, the short-run supply curve of a firm is the rising portion of its Marginal Cost (MC) curve which lies above the minimum point of the Average Variable Cost (AVC) curve. \begin{center} \begin{tikzpicture}[scale=0.8] \draw[->] (0,0) -- (6,0) node[below] {Output}; \draw[->] (0,0) -- (0,5) node[left] {Price, Cost}; \draw[thick, color=green] (1.5,4) .. controls (2.5,1.5) and (3,1.6) .. (4,4) node[above] {AVC}; \draw[thick, color=blue, line width=1.5pt, domain=2.7:4.5] plot (\x, {0.5*(\x-2)^2 + 1}) node[right] {Supply Curve}; \draw[thick, color=purple, dashed, domain=1:2.7] plot (\x, {0.5*(\x-2)^2 + 1}); \node at (4,3) {MC}; \draw[dashed] (2.7,1.8) -- (0,1.8) node[left] {Shutdown Price}; \fill (2.7,1.8) circle (2pt); \end{tikzpicture} \end{center}

Step 3: Long-Period Supply Curve:
In the long run, all costs are variable. A firm will continue to produce only if the price is greater than or equal to its Long-Run Average Cost (LAC). If the price falls below LAC, the firm will exit the industry. Therefore, the long-run supply curve of a firm is the rising portion of its Long-Run Marginal Cost (LMC) curve which lies above the minimum point of the Long-Run Average Cost (LAC) curve. \begin{center} \begin{tikzpicture}[scale=0.8] \draw[->] (0,0) -- (6,0) node[below] {Output}; \draw[->] (0,0) -- (0,5) node[left] {Price, Cost}; \draw[thick, color=green] (1,4) .. controls (3,1.5) and (4.5,2) .. (5.5,4) node[above] {LAC}; \draw[thick, color=blue, line width=1.5pt, domain=3.3:5] plot (\x, {0.5*(\x-2.5)^2 + 1}) node[right] {Supply Curve}; \draw[thick, color=purple, dashed, domain=1:3.3] plot (\x, {0.5*(\x-2.5)^2 + 1}); \node at (4.5,3) {LMC}; \draw[dashed] (3.3,1.8) -- (0,1.8) node[left] {Exit Price}; \fill (3.3,1.8) circle (2pt); \end{tikzpicture} \end{center}