Behavior of a Firm | Profit Maximization Problem of a Firm | Price Taking Behavior
Till now, in previous sessions we discussed in detail the functional areas of firm in the context of production level of the firm and cost incurred while undertaking the process of production. We studied the production function of the firm which gives the maximum output that a firm can produce for given combination of factors of production. Then we discussed the costs incurred in Short Run and Long Run for a firm including the Average costs and Marginal Cost. So the focus was on the production process undertaken including the costs incurred while carrying out production.
Now moving forward, we will focus on the decision making by a firm as regards to how much output the firm should produce. The answer to this question cannot be based on any single criteria but could be a result of several factors and forces working simultaneously behind the same.
But one of the most important assumption regarding the firm’s behavior that needs to be kept in central focus while answering the question as regards to how much output the firm should produce is – the firm is simply a profit maximizer. So to say, answer regarding what output level a firm will produce is based on the assumption that a firm is a ruthless profit maximizing entity. Meaning a firm will produce and sell that amount of output which will maximize its profits. Here it is also assumed that the firm sells all of the output it produces and hence the output produced and output sold are the same and are used interchangeably.
While studying the consumer theory we discussed about the problem of economic decision making that consumers face in the face of scared and limited resources and unlimited needs and wants. Hence the consumer then needs to prioritize the needs and wants. So the consumer’s problem was to derive maximum utility from the available scare resources.
In the same manner, here in case of firms, the problem of the firm is to earn maximum profit while carrying out the production process and then selling the output. The firms carry out the production process. In order undertake the process of production, firm incurs costs. And on selling the output produced, firm earns revenues. The excess of revenue over the costs is the firm’s profit. And the firm wants to maximize the profit. So the problem of the firm or the decision making the firm is required to make is to undertake the activity of producing and selling output in a manner which generates the maximum profit for the firm.
But before jumping into discuss the profit maximization problem of a firm, it is important to understand the market environment in which the firm operates. Based on unique features and characteristics, there are different market environment. The firms working in different market environment solves the profit maximization problem according to the forces and factors which are into play in that environment.
One of the types of market environment is called Perfect Competition. In session going forward, we will the study the firm’s profit maximization problem and its solution while assuming that the firm function in a Perfect Competition market environment.
Here it becomes important to understand first in detail about the Perfect Competition.
Perfect Competition
A market environment which exhibits the following features or characteristics is known as Perfectly Competitive Market.
1)- Large number of buyers and Sellers
The perfectly competitive market consists of large number of buyers and sellers. Thus this means that every individual buyer and seller is very small component or constituent of the market and hence no individual buyer or seller can exert influence on the market through their size.
2)- Homogenous Product
Every firm operating in a perfectly competitive market produces and sells homogenous products meaning the product of a particular firm cannot be differentiated from product produced by other firms. The products of all the firms are identical and hence the buyer can buy the product from any of the available seller in the market and will get the same product.
3)- Free Entry and Exit
Any new number of firms can enter the market to sell their product and any of the existing firm can exit from the market without any barriers. So to say, there is free entry and exit for the firms in a perfectly competitive market. If entry in the market would be made difficult then the number of firms operating in the market would have been small.
4)- Perfect Information
Perfect Information means all the buyers and sellers operating in the market are well aware and informed about the relevant information of the product’s price, quality as well as other details pertaining to the product and even the information about the market.
Price Taking Behavior
The presence of all of the above features in a perfectly competitive market leads to one of the most unique and distinguishing characteristics or behavior of perfect competition which is known as the Price Taking Behavior.
Price taking behavior of perfect competition can be explained into two different contexts; from viewpoint of a firm and from viewpoint of a buyer.
1)- From viewpoint of a firm
The price taking behavior of a firm means that the firm believes that if it tries to sell the product above the market price, the firm will not able to sell any quantity of its output. At the same time, if the firm sets the price of its product less than or equal to the market price, it will be able to sell as much quantity of the product as it wishes.
2)- From viewpoint of a buyer
The price taking behavior of a buyer means that the buyer believes that if the buyer will ask for a price below the market price of the product then now firm will be willing to sell to that buyer. At the same time, if the buyer asks for a price greater than or equal to the market price, the buyer will be able to buy as much quantity from the market as desired.
The price taking behavior can be justified only when all the above said features of perfect competition exists, i.e., there are many buyers and sellers, all sellers are selling homogeneous product, and all of them have perfect information. Suppose, a firm tries to sell the product at higher price than the market price. Now all the other firms in a perfectly competitive market sells the same product and all the buyers are well aware about the prevailing market price of the product. Hence the firm in question which raised the prices of product above the market price will lose all its customers with immediate effect. And as there are large number of firms operating in the market, the buyers who have switched from the above firm in question are easily accommodated and no adjustment problems arises. Hence this phenomenon perfectly explains the Price Taking behavior in a perfectly competitive market.
Conclusion
1)- Large number of buyers and Sellers
The perfectly competitive market consists of large number of buyers and sellers. Thus this means that every individual buyer and seller is very small component or constituent of the market and hence no individual buyer or seller can exert influence on the market through their size.
2)- Homogenous Product
Every firm operating in a perfectly competitive market produces and sells homogenous products meaning the product of a particular firm cannot be differentiated from product produced by other firms. The products of all the firms are identical and hence the buyer can buy the product from any of the available seller in the market and will get the same product.
3)- Free Entry and Exit
Any new number of firms can enter the market to sell their product and any of the existing firm can exit from the market without any barriers. So to say, there is free entry and exit for the firms in a perfectly competitive market. If entry in the market would be made difficult then the number of firms operating in the market would have been small.
4)- Perfect Information
Perfect Information means all the buyers and sellers operating in the market are well aware and informed about the relevant information of the product’s price, quality as well as other details pertaining to the product and even the information about the market.
Price Taking Behavior
The presence of all of the above features in a perfectly competitive market leads to one of the most unique and distinguishing characteristics or behavior of perfect competition which is known as the Price Taking Behavior.
Price taking behavior of perfect competition can be explained into two different contexts; from viewpoint of a firm and from viewpoint of a buyer.
1)- From viewpoint of a firm
The price taking behavior of a firm means that the firm believes that if it tries to sell the product above the market price, the firm will not able to sell any quantity of its output. At the same time, if the firm sets the price of its product less than or equal to the market price, it will be able to sell as much quantity of the product as it wishes.
2)- From viewpoint of a buyer
The price taking behavior of a buyer means that the buyer believes that if the buyer will ask for a price below the market price of the product then now firm will be willing to sell to that buyer. At the same time, if the buyer asks for a price greater than or equal to the market price, the buyer will be able to buy as much quantity from the market as desired.
The price taking behavior can be justified only when all the above said features of perfect competition exists, i.e., there are many buyers and sellers, all sellers are selling homogeneous product, and all of them have perfect information. Suppose, a firm tries to sell the product at higher price than the market price. Now all the other firms in a perfectly competitive market sells the same product and all the buyers are well aware about the prevailing market price of the product. Hence the firm in question which raised the prices of product above the market price will lose all its customers with immediate effect. And as there are large number of firms operating in the market, the buyers who have switched from the above firm in question are easily accommodated and no adjustment problems arises. Hence this phenomenon perfectly explains the Price Taking behavior in a perfectly competitive market.
Conclusion
In this session, we discussed in detail regarding the profit maximization problem of the firm and then we moved on to discuss in detail about the Perfect Competition.
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