BBA online tuition, B.Com Online tuition, MBA online tuition, MBA projects and assignments solution
7. Explain why the demand curve facing a perfectly competitive firm is assumed to be perfectly elastic.
In a
perfectly competitive market, it is assumed a firm would have a perfectly
elastic demand. This is because if they increased the price, the consumers with
perfect information would switch to other firms who offer the identical
product. In perfect competition, we say a firm is a price taker. This means its
demand curve is perfectly elastic; it has to accept the market price. A
perfectly competitive industry is comprised of a large number of relatively
small firms that sell identical products. Each perfectly competitive firm is so
small relative to the size of the market that it has no market control; it has
no ability to control the price. In other words, it can sell any quantity of
output it wants at the going market price. This translates into a horizontal or
perfectly elastic demand curve. It also translates in equality between price,
average revenue, and marginal revenue.
The
market price in a perfectly competitive market is determined by the market
supply and demand curves. An individual firm in that market cannot charge more
than the market price and will not charge less. So, the demand curve facing an
individual firm is horizontal at the market price, that is, it is perfectly
elastic.
The
demand and supply curves for a perfectly competitive market are illustrated in
Figure (a); the demand curve for the output of an individual firm
operating in this perfectly competitive market is illustrated in
Figure (b).
In a perfectly competitive market, the market demand curve is a downward sloping line, reflecting the fact
that as the price of ordinary good increases, the quantity demanded of that
good decrease. Price is determined by the intersection of market demand and
market supply; individual firms do not have any influence on the market price
in perfect competition.
Once the market price has
been determined by market supply and demand forces, individual firms become
price takers. Individual firms are forced to charge the equilibrium price of
the market or consumers will purchase the product from the numerous other firms
in the market charging a lower price.
The demand curve for an individual firm is thus equal to the equilibrium price of the market. Individual firm's equilibrium quantity of output will be completely determined by the amount of output the individual firm chooses to supply. The difference in the slopes of the market demand curve and the individual firm's demand curve is due to the assumption that each firm is small in size.
A perfectly competitive
firm faces a perfectly elastic demand curve at the market price. Profits are
maximized by producing the quantity at which marginal revenue equals marginal
cost.
Since price equals
marginal revenue for a perfect competitor, profits are maximized at the
quantity of output at where price equals marginal cost. This occurs where the
marginal cost curve intersects the demand curve.
The profit maximizing
quantity is 15 units of output. The price is the market price of $10. The firm's
average cost is $6 per unit of output. So, the firm makes a profit of $10 - $6
= $4 per unit of output. Total profits are 15 x $4 = $60.
