THE THEORY OF THE FIRM AND PERFECT COMPETITON

Define the term market.

In Economics the word ‘Market’ refers to the direct or indirect contact between the buyers and sellers of a particular commodity at a price and at a place which could be even the world.

The following requirements are to be met for the existence of a market.  

1.  Existence of a commodity which will be bought and sold. 

2.  Existence of buyers and sellers.

3.  Prevalence of a price.

4.  A place, which could be a region, country or the entire world through which exchange takes place. Ex: internet.       

  

Distinguish between a firm and industry.

A firm is a single producing unit where as group of firms constitutes the industry.   Ex. TVS motors, Bajaj, Hero motors, are firms and together they constitute the automobile industry.

Explain the Features of Perfect Competition.

Meaning:  It refers to a Market situation in which there are a large Number of Buyers and sellers who deal with identical products at an equilibrium price which is determined by the market forces of demand and supply.

Features:

1.  There are a large number of Buyers and Sellers in the market.

2.  There is free competition among the buyers and sellers.

3.  No individual buyer or seller can influence the price of the commodity by his own action.

4.  Products of all firms will be identical.

5.  There is one price for a commodity throughout the market.

6.  Any new firm is free to enter the industry and any existing firm is free to leave the industry.

7.  All the buyers and sellers have perfect market information.

8.  Each firm is a Price taker.

9.  There is absence of Transport Cost.

10.There is free mobility of factors of production.

11.The demand for the product is perfectly elastic.

Explain how price and output is determined under Perfect Competition. or

Show how the invisible hand guides both producers and consumers towards equilibrium.

The process of determination of price by the forces of demand and supply is called Price mechanism.  Prof. Adam smith referred this as invisible hand which directs and guides both the producers and consumers towards equilibrium.

Equilibrium means a state of rest.  At Equilibrium price, quantity of demand and supply will be equal.  Market equilibrium is determined by the forces of market (total) demand and market (total) supply.

     The market supply curve slopes upwards from left to right and the market demand curve slopes downwards from left to right.  These two curves intersect at a point which determines the equilibrium price and the equilibrium output.

     The following table shows the demand and supply schedule for sugar.

Price sugar in Rs	QD ( in tones)	QS( in tones)
10	100	20
20	80	40
30	60	60
40	40	80
50	20	100

When Price of sugar per kg is Rs 10, the quantity demanded is 100 tonnes and the quantity supplied is 20 tonnes.  When price increases to Rs. 20, the quantity demanded is 80 tonnes and the quantity supplied is 40 tonnes.  At Rs 30 per Kg, quantity demanded is equal to the quantity supplied at 60 tonnes.  Therefore, Rs 30 is the equilibrium price and 60 tonnes of sugar is the equilibrium output.  Any price higher than Rs 30 leads to excess supply and lower than Rs 30 leads to excess demand.  This is explained with the help of a diagram. 

In the diagram, quantity of demand and supply is measured on OX axis and price is measured on OY axis.  SS is the Supply curve and DD is the demand curve.  E is the intersection point, where the quantity demanded is equal to the quantity supplied. OM is the Equilibrium quantity and OP is the equilibrium price.  If price falls to OP1, Demand is greater than supply by Kl.  The sellers want to supply only OM1 quantity of supply but demand will be OM2.  The buyers now compete with each other in order to obtain the goods and are ready to pay a higher price than OP1.  so price starts rising till OP level is reached, where quantity supplied will be equal to the quantity demanded.

If the price rises to OP2, then demand will be less than supply by NM.  In order to dispose this excess supply the sellers will compete with each other and bring down the price to OP.  Thus if price is above or below the equilibrium price, the invisible hand will operate to bring the price to the level at which the quantity supplied will be equal to quantity demanded.