What is the shape of the demand curve faced by a firm in perfect competition?
a. Downward sloping demand curve
b. Elastic demand curve at the market price
c. Inelastic demand curve at the market price
d. None of the above
The correct answer and explanation is:
Correct Answer: b. Elastic demand curve at the market price
In a perfectly competitive market, the demand curve faced by an individual firm is perfectly elastic. This means the firm can sell any quantity of its product at the market price but cannot charge a higher price. If the firm attempts to raise its price above the market level, consumers will simply purchase the product from other sellers because the products are identical, and information is perfectly available in the market.
This perfect elasticity of demand is represented graphically by a horizontal line at the market price level. It reflects that the firm is a price taker, not a price maker. The market sets the price based on the overall intersection of industry demand and supply, and individual firms must accept this price. They have no control over the price due to the large number of sellers and identical nature of the goods being sold.
The firm’s revenue increases proportionally with the quantity sold since each additional unit is sold at the same market price. Therefore, marginal revenue (MR) and average revenue (AR) are equal and constant. This unique situation results in a horizontal demand curve for each firm, which corresponds to perfect price elasticity.
This condition differs from other market structures. For example, in monopoly or monopolistic competition, firms face a downward-sloping demand curve, meaning they must lower the price to sell more units. In contrast, under perfect competition, the firm’s product is a perfect substitute for the product of any other firm, eliminating pricing power.
In summary, a firm in perfect competition faces a perfectly elastic demand curve at the market price. This condition is fundamental to understanding how such firms operate, how they set output levels, and how they make decisions in both the short and long run.