Revenue Structure of a Firm under Perfect Competition

One of the distinguishing characteristics of perfect competition is the presence of an infinite number of firms producing homogeneous product.  The number of firms is so large that a single firm’s contribution to the total output of the product in the market is insignificant or microscopic.  The firm under perfect competition can neither influence the price nor the output in the market.  In fact, it has to take the going-market price, i.e. the price prevailing in the market as is determined by the forces of demand and supply.  It is in this context that the firm under perfect competition is referred to as price-taker and not a price maker.  The revenue structure of the firm under perfect competition is influenced by this characteristic of perfect competition.

Let us assume that the price of the product X as determined in the market by the forces of demand and supply is 5$ per unit and that the firm, working under perfect competition has no other option but to sell its product also at the going market price i.e. 5$. When it sells one unit it will get 5$ as total revenue.  We can thus proceed to prepare the revenue schedule of the firm as follows:

Units of x TR($) AR($) MR($)
1 5 5 5
2 10 5 5
3 15 5 5
4 20 5 5
5 25 5 5

The revenue schedule indicates that as the firm goes on selling more and more units its total revenue goes on increasing.  Each unit is being sold at 5$.  The price is given and constant and thus the AR (which is equal to price) remains the same.  Besides every additional unit of X is also sold at 5$ the Marginal Revenue (additional revenue from additional unit) also remains 5$.

Let us now translate the revenue schedule into revenue curves.  The Total Revenue curve starts from the origin and slopes upwards from left to right.  But the AR curve is horizontal and what is still more important is that the MR curve coincides with the AR curve.  There is no difference between AR and MR.  For a firm under perfect competition AR = MR.  Thus, the horizontality of AR curve is the acid test of  a firm under perfect competition.  In other words if any firm is facing a horizontal AR curve then we can at once conclude that it is working under the condition of perfect competition.  The AR curve explains the price and output relationship and is thus also the demand curve of the firm’s product.  It is important to note that the demand curve of the firm is different from the industry demand curve.  The industry demand curve is downward sloping, i.e. it slopes downwards from left to right indicating that for the industry to sell more of its output the price should be low.  At lower price, more units of industry’s product will be demanded in the market.

But the demand curve of a firm is horizontal, as explained above, as the firm under perfect competition is just a price-taker.  Whatever number of units it sells it will have to sell it at the going market price for the industry’s product which is determined by the interaction of the forces of demand and supply of the product of the industry in the market.  It is obvious that the industry’s demand curve represents a much larger quantity compared to that represented by the firm’s demand curve.

Credit: Economics For Managers-MGU

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