AS & A-Level Economics — Competition, Monopoly and Oligopoly
PublicOriginal Deckloop economics study material on competition, monopoly and oligopoly, with 100 practice cards and 20 concept explainers. Includes worked applications and analytical reasoning.
Economics
EN
A-Level
100 cards
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Price-Taking Firms and Horizontal Demand
A direct consequence of the assumptions of perfect competition is that individual firms are 'price takers'. This means they have no power to influence the market price of their product. Because each firm's output is an infinitesimally small fraction of the total market supply, selling more or less does not affect the overall market price. As a result, the demand curve facing an individual perfectly competitive firm is perfectly elastic, appearing as a horizontal line at the prevailing market price. For such a firm, its Marginal Revenue (MR), Average Revenue (AR), and Price (P) are all equal, as each additional unit sold adds exactly the market price to total revenue.
Key points
- Individual firms are too small to influence market price.
- They must accept the market-determined price.
- The firm's demand curve is perfectly elastic (horizontal) at the market price.
- For a price taker, Price (P) = Marginal Revenue (MR) = Average Revenue (AR).
Worked example
Question
The market price for a standard unit of organic wheat is 25 monetary units. A single farm, 'Green Acres', operates in this perfectly competitive market. If Green Acres sells 1,000 units, what is its Average Revenue (AR) and Marginal Revenue (MR)? If it decides to sell 1,001 units, how does its MR for the 1,001st unit compare to its AR?
Solution
1. Identify the market structure: Perfectly competitive, so the firm is a price taker.
2. Apply the price-taker rule: For a price-taking firm, P = AR = MR.
3. Calculate AR and MR for 1,000 units: Since P = 25, AR = 25 and MR = 25.
4. Calculate MR for the 1,001st unit: As the firm is a price taker, selling one more unit does not change the market price. Therefore, the MR for the 1,001st unit is also 25 monetary units.
5. Compare: The MR for the 1,001st unit is equal to its AR (and P).
For Green Acres, operating in a perfectly competitive market, its Average Revenue (AR) and Marginal Revenue (MR) are both 25 monetary units when selling 1,000 units. If it sells 1,001 units, the Marginal Revenue for that 1,001st unit will still be 25 monetary units. This is because a price-taking firm faces a perfectly elastic demand curve, meaning P = AR = MR at all output levels.
2. Apply the price-taker rule: For a price-taking firm, P = AR = MR.
3. Calculate AR and MR for 1,000 units: Since P = 25, AR = 25 and MR = 25.
4. Calculate MR for the 1,001st unit: As the firm is a price taker, selling one more unit does not change the market price. Therefore, the MR for the 1,001st unit is also 25 monetary units.
5. Compare: The MR for the 1,001st unit is equal to its AR (and P).
For Green Acres, operating in a perfectly competitive market, its Average Revenue (AR) and Marginal Revenue (MR) are both 25 monetary units when selling 1,000 units. If it sells 1,001 units, the Marginal Revenue for that 1,001st unit will still be 25 monetary units. This is because a price-taking firm faces a perfectly elastic demand curve, meaning P = AR = MR at all output levels.
Common pitfalls
- Misconception: The market demand curve is also horizontal. Correction: The market demand curve for the entire industry is downward sloping. Only the demand curve for an individual, price-taking firm is horizontal.
- Misconception: A firm can choose to sell at a slightly higher price to increase revenue. Correction: If a perfectly competitive firm attempts to sell at a price even slightly above the market price, it will sell zero units due to homogeneous products and perfect information; consumers will simply buy from other sellers.
Prerequisites
- Deck 11 — Assumptions of Perfect Competition: Understanding the assumptions of perfect competition (many small firms, homogeneous products, perfect information) is essential to explain why individual firms are price takers.
- Deck 10 — Revenue under Price-Taking and Price-Setting: To understand the concepts of average revenue (AR) and marginal revenue (MR) and how they relate to price for a price-taking firm, leading to a horizontal demand curve.
- Deck 03 — Elasticity Categories and Limiting Cases: To understand the meaning of 'perfectly elastic' demand and its graphical representation as a horizontal line.