Theory of the Firm 5

i) Legal constraints/Government policy

In some situations, the laws may restrict the growth of a firm.

In such circumstances the existing firms remain small.

j) Small capital requirements

As opposed to large scale firms, small firms require little amounts of capital to start and operate.

Implication of production activities on environmental and community health.

As production activities take place in a given area, the environment and the health of the community around may be adversely affected by these activities.

Some of these effects include:

a) Air pollution

This is caused by waste which is discharged into the atmosphere leading to contamination of the air. Such waste may be in funs of industrial emissions and toxic chemicals from the firms.

These pollutants cause air-borne diseases.
Acid rain due to such emission may also affect plants.

Product Market

The term ‘market’ is usually used to mean the place where buyers and sellers meet to transact business.

In Business studies, however, the term ‘market’ is used to refer to the interaction of buyers and sellers where there is an exchange of goods and services for a consideration.

NOTE: The contact between sellers and buyers may be physical or otherwise hence a market is not necessarily a place, but any situation in which buying and selling takes place.

A market exists whenever opportunities for exchange of goods and services are available, made known and used regularly.


i) Product market; Is a particular market in which specific goods and services are sold and with particular features that distinguish it from the other markets.

- The features are mainly in terms of the number of sellers and buyers and whether the goods sold are homogeneous or heterogeneous.

- Product market is also referred to as market structure.
- Markets may be classified according to the number of firms in the industry or the type of products sold in them.

Types of Product Market

The number of firms operating in a particular market will determine the degree of competition that will exist in a given industry.

In some markets there are many sellers meaning that the degree of competition is very high,
where as in other markets there is no competition because only one firm exists.

When markets are classified according to the degree of competition, there are four main types, these are;

i) Perfect competition

ii) Pure monopoly(monopoly)

iii) Monopolistic competition

iv) Oligopoly

i) Perfect competition

The word ‘perfect’ connotes an ideal situation.
This kind of situation is however very rare in real life; a perfect competition is therefore a hypothetical situation.

This is a market structure in which there are many small buyers and many sellers who produce a homogeneous product.

The action of any firm in this market has no effect on the price and output levels in the market since its production is negligible.

Features of Perfect Competition

a) Large number of buyers and sellers: The buyers and sellers are so many that separate actions of each one of them have no effect on the market.

This implies that no single buyer or seller can influence the price of the commodity.

This is because a single firms (sellers) supply of the product is so small in relation to the total supply in the industry. Similarly, the demand of one buyer is so small compared to the total demand of one buyer is so small
compared to the total demand in the market that he/she cannot influence the price.

Firms (suppliers) in such a market structure are therefore price takers i.e. they accept the prevailing market price for their products.

b) Identical or homogeneous products:

Commodities from different producers are identical in all aspects e.g. size; brand and quality such that one cannot distinguish them. Buyers cannot therefore show preference for the products of one firm over those of the other.

c) Perfect knowledge of the market:

Each buyer and seller has perfect knowledge about the market and therefore no one would affect business at any price other than the equilibrium price (market price).

If one firm raises the price of its commodity above the prevailing market price, the firm will
make no sale since consumers are aware of other firms that are offering a lower price i.e. market price.

All firms (sellers) are also assumed to know the profits being made by other firms in the industry (in selling the

d) Freedom of entry or exit in the industry;

The buyers and sellers have the freedom to enter and leave the market at will i.e. firms are free to join the market and start production so long as the prevailing market price for the commodity guarantees profit.

However if conditions change the firms are free to leave in order to avoid making loss.

In this market structure, it is assumed that no barrier exists in entering or leaving the industry.

e) Uniformity of buyers and sellers;

All buyers are identical in the eyes of the

There are therefore, no advantages or disadvantages of selling to particular buyers. Similarly, all the sellers are identical and hence there would be no special benefit derived from buying from a certain supplier.

f) No government interference;

The government plays no part in the operations of the industry.

The price prevailing in the market is determined strictly by the interplay of demand and supply. There should be no government intervention in form of taxes and subsidies, quotas, price
controls and other regulations.

g) No excess supply or demand;

The sellers are able to sell all what they
supply into the market. This means that there is no excess supply.

Similarly, the buyers are able to buy all what they require with the result that there is no difficult in supply.

h) Perfect mobility of factors of production

The assumption here is that producers are able to switch factors of production from producing one
commodity to another depending on which commodity is more profitable to sell.

Factors of production are also freely movable from one geographical area to another.

i) No transport costs;

The assumption here is that all sellers are located in one area, therefore none of them incurs extra transport costs or carriage of goods.

The sellers cannot hence charge higher prices to cover the cost of transport. Buyers, on the other hand, would not prefer some sellers to others in an attempt to cut down on transport costs.

NOTE: The market (perfect competition) has normal demand and supply curves.

The individual buyers demand curve is however; perfectly elastic.

since one can buy all what he/she wants at the equilibrium price. Similarly, the individual sellers supply curve is also perfectly elastic because one can sell all what he/she produces at the equilibrium price.

Perfect competition market hold on the following assumptions;

i) There are no transport costs in the industry

ii) Buyers and sellers have perfect knowledge of the market

iii) Factors of production are perfectly mobile

iv) There is no government interference

Examples of perfect competitions are very difficult to get in the real life but
some transactions e.g. on the stock exchange market, are very close to this.

Criticism of the concept of perfect competition
In reality, there is no market in which perfect competition exists.

This is due to the following factors:

i) Very few firms produce homogenous products. Even if the products were fairly identical, consumers are unlikely to view them as such.

ii) In real situations, consumers prefer variety for fuller satisfaction of their wants; hence homogenous products may not be very popular in these.


iii) There is a common tendency towards large-scale operation.

This tendency works against the assumption of having many small firms in an industry.

iv) Firms are not found in one place to cut down on transport costs as this market structure requires.

v) Governments usually interfere in business activities in a variety of ways in the interest of their citizens.
The assumption of non-interference by the state is therefore unrealistic in real world situations.

vi) Information does not freely flow in real markets

so as to make both sellers and buyers fully knowledgeable of happenings in all parts of a given market.


A monopoly is a market structure in which only one firm produces a commodity which has no close substitutes.

Some of the features in this market structure are:

a) One seller or producer; supplying the entire market with a product that has no close substitute consumers therefore have no option but to use the commodity from the monopolist to satisfy their need.

Theory of the Firm 1 | Theory of the Firm 2 |
Theory of the Firm 3 | Theory of the Firm 4 |
Theory of the Firm 5 | Theory of the Firm 6 |

Click here to post comments

Join in and write your own page! It's easy to do. How? Simply click here to return to Business Studies FAQ.

Scholarship 2020/21

Undergraduate Scholarships 2020/2021
Masters Scholarships,
PhD Scholarships,
International Scholarships.