Question

Why do we model a competitive firm with assumptions that seem to be unrealistic? Why do we see that marginal cost tends to increase with each unit of output? Why do we observe a U-shaped Average Cost Curve? Why is it the Marginal Revenue equal to the Price? What does it mean that the Marginal Revenue curve is a flat horizontal curve? Why do we assume that companies are profit-maximizing institutions? After all, they may care about something else besides profit. Also, what kind of information is profit communicating to society?

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Any help is greatly appreciated!

Answer 1

1. Competitive firm is the simplest form of the market which we assume. We consider unrealistic assumptions just to describe in a way of completeness. Moreover, it is more suited to firms in the classical period. Here we assume both buyer and seller have perfect information, all are price takers ..etc. All over here we simplified, how the market actually performs with these unrealistic assumptions for better understanding.

2.Marginal cost curve tells, change in the cost of production for a unit change in output. So increasing MC means for each increase in output Cost of production is also increasing. The reason is as we produce more there will be inefficiencies that will come in production thus cost of production increases. Also, resources are over and above utilized than the optimum use.

3. Average cost in perfect competition is u shaped because. When we start producing, initially the cost of production falls. Because we will be moving towards the optimum utilization of resources, so we will have efficiencies and reduction of the overall cost. But after a point, means after the optimum utilization of resources MC starts increasing heavily, thus the overall average curve also starts rising, because of overutilization and inefficiencies of resources.

4. Here marginal revenue is equal to price. It is because as we said all are price takers. So the price for each unit is fixed and constant. So Marginal revenue means a change in revenue earned when I sell an additional unit of a quantity. So, here each unit has an equal price and each additional unit sold will generate revenue equal to the price. Thus both are the same here.

5. MR curve flat horizontal means that, it is fixed and won't change as the quantity of output sold changes like price in perfect competition. Same explanation from above.

6. It is rationality because all firms are not operating for community services for free generally. Their motive is profit. So for a given circumstance, they try to maximize their profit. It is true that some companies care more about something else than profit. But we took this assumption on a general trend of firms n a given situation.

7. Based on the perfect competition model, profit in the short-run communicate that more firms can step in for this particular product production to earn a profit. It is a short run phenomena. When more firms step in , in the long run firms will earn only normal profit rather than supernormal profit that we talked in the short run.