Learning Objectives
- Determine profits and costs by comparing total revenue and total cost
- Use marginal revenue and marginal costs to find the level of output that will maximize the firm’s profits
How Perfectly Competitive Firms Make Output Decisions
Aperfectly competitive firm has only one major decision to make—namely, what quantity to produce. To understand why this is so, consider the basic definition of profit:
[latex]\begin{array}{l}\text{Profit}=\text{Total revenue}-\text{Total cost}\hfill \\ \text{ }=\left(\text{Price}\right)\left(\text{Quantity produced}\right)-\left(\text{Average cost}\right)\left(\text{Quantity produced}\right)\hfill \end{array}[/latex]
Since a perfectly competitive firm must accept the price for its output as determined by the product’s market demand and supply, it cannot choose the price it charges. Rather, the perfectly competitive firm can choose to sell any quantity of output at exactly the same price. This implies that the firm faces a perfectly elastic demand curve for its product: buyers are willing to buy any number of units of output from the firm at the market price. When the perfectly competitive firm chooses what quantity to produce, then this quantity—along with the prices prevailing in the market for output and inputs—will determine the firm’s total revenue, total costs, and ultimately, level of profits.
Determining the Highest Profit by Comparing Total Revenue and Total Cost
A perfectly competitive firm can sell as large a quantity as it wishes, as long as it accepts the prevailing market price. Total revenue is going to increase as the firm sells more, depending on the price of the product and the number of units sold. If you increase the number of units sold at a given price, then total revenue will increase. If the price of the product increases for every unit sold, then total revenue also increases.
As an example of how a perfectly competitive firm decides what quantity to produce, consider the case of a small farmer who produces raspberries and sells them frozen for $4 per pack. Sales of one pack of raspberries will bring in $4, two packs will be $8, three packs will be $12, and so on. If, for example, the price of frozen raspberries doubles to $8 per pack, then sales of one pack of raspberries will be $8, two packs will be $16, three packs will be $24, and so on.
Total revenue and total costs for the raspberry farm are shown in Table 1 and also appear in Figure 1.
| Quantity (Q) | Total Revenue (TR) | Total Cost (TC) | Profit |
|---|---|---|---|
| 0 | $0 | $62 | −$62 |
| 10 | $40 | $90 | −$50 |
| 20 | $80 | $110 | −$30 |
| 30 | $120 | $126 | −$6 |
| 40 | $160 | $138 | $22 |
| 50 | $200 | $150 | $50 |
| 60 | $240 | $165 | $75 |
| 70 | $280 | $190 | $90 |
| 80 | $320 | $230 | $90 |
| 90 | $360 | $296 | $64 |
| 100 | $400 | $400 | $0 |
| 110 | $440 | $550 | $−110 |
| 120 | $480 | $715 | $−235 |
In Figure 1, the horizontal axis shows the quantity of frozen raspberries produced. The vertical axis shows both total revenue and total costs, measured in dollars. The total cost curve intersects with the vertical axis at a value that shows the level of fixed costs, and then slopes upward, first at a decreasing rate, then at an increasing rate. In other words, the cost curves for a perfectly competitive firmhave the same characteristics as the curves that we covered in the previous module on production and costs.
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Figure 1. Total Revenue, Total Cost and Profit at the Raspberry Farm. Total revenue for a perfectly competitive firm is an upward sloping straight line. The slope is equal to the price of the good. Total cost also slopes up, but with some curvature. At higher levels of output, total cost begins to slope upward more steeply because of diminishing marginal returns. Graphically, profit is the vertical distance between the total revenue curve and the total cost curve.This is shown as the smaller, downward-curving line at the bottom of the graph. The maximum profit will occur at the quantity where the difference between total revenue and total cost is largest.
Based on its total revenue and total cost curves, a perfectly competitive firm like the raspberry farm can calculate the quantity of output that will provide the highest level of profit. At any given quantity, total revenue minus total cost will equal profit. One way to determine the most profitable quantity to produce is to see at what quantity total revenue exceeds total cost by the largest amount.
Figure 1 shows total revenue, total cost and profit using the data from Table 1. The vertical gap between total revenue and total cost is profit, for example, at Q = 60, TR = 240 and TC = 165. The difference is 75, which is the height of the profit curve at that output level. The firm doesn’t make a profit at every level of output. In this example, total costs will exceed total revenues at output levels from 0 to approximately 30, and so over this range of output, the firm will be making losses. At output levels from 40 to 100, total revenues exceed total costs, so the firm is earning profits. However, at any output greater than 100, total costs again exceed total revenues and the firm is making increasing losses. Total profits appear in the final column of Table 1.Maximum profit occurs at an output between 70 and 80, when profit equals $90.
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A higher price would mean that total revenue would be higher for every quantity sold. Graphically, the total revenue curve would be steeper, reflecting the higher price as the steeper slope. A lower price would flatten the total revenue curve,meaning that total revenue would be lower for every quantity sold. What happens if the price drops low enough so that the total revenue line is completely below the total cost curve; that is, at every level of output, total costs are higher than total revenues? In this instance, the best the firm can do is to suffer losses. However, a profit-maximizing firm will prefer the quantity of output where total revenues come closest to total costs and thus where the losses are smallest.
Comparing Marginal Revenue and Marginal Costs
The approach that we described in the previous section, using total revenue and total cost, is not the only approach to determining the profit maximizing level of output. In this section, we provide an alternative approach which uses marginal revenue and marginal cost.
Firms often do not have the necessary data they need to draw a complete total cost curve for all levels of production. They cannot be sure of what total costs would look like if they, say, doubled production or cut production in half, because they have not tried it. Instead, firms experiment. They produce a slightly greater or lower quantity and observe how it affects profits. In economic terms, this practical approach to maximizing profits means examining how changes in production affect revenues and costs.
In the module on production and dosts, we introduced the concept of marginal cost—the change in total cost from producing one more unit of output. Similarly, we can define marginal revenue as the change in total revenue from selling one more unit of output. As mentioned before, a firm in perfect competition faces a perfectly elastic demand curve for its product—that is, the firm’s demand curve is a horizontal line drawn at the market price level. This also means that the firm’s marginal revenue curve is the same as the firm’s demand curve. Every time a consumer demands one more unit, the firm sells one more unit and revenue increases by exactly the same amount equal to the market price. In this example, every time the firm sells a pack of frozen raspberries, the firm’s revenue increases by $4, as you can see in Table 2. This condition only holds for price taking firms in perfect competition where:
[latex]\text{marginal revenue = price}[/latex]
The formula for marginal revenue is:
[latex]\text{marginal revenue = }\frac{\text{change in total revenue}}{\text{change in quantity}}[/latex]
| Table 2. Marginal Revenue for Raspberries | |||
|---|---|---|---|
| Price | Quantity | Total Revenue | Marginal Revenue |
| $4 | 1 | $4 | – |
| $4 | 2 | $8 | $4 |
| $4 | 3 | $12 | $4 |
| $4 | 4 | $16 | $4 |
Try It
Notice that marginal revenue does not change as the firm produces more output. That is because the price is determined by supply and demand and does not change as the farmer produces more (keeping in mind that, due to the relative small size of each firm, increasing their supply has no impact on the total market supply where price is determined).
Figure 2. Market Price. The equilibrium price of raspberries is determined through the interaction of market supply and market demand at $4.00.
Since a perfectly competitive firm is a price taker, it can sell whatever quantity it wishes at the market-determined price. Marginal cost, the cost per additional unit sold, is calculated by dividing the change in total cost by the change in quantity. The formula for marginal cost is:
[latex]\text{marginal cost = }\frac{\text{change in total cost}}{\text{change in quantity}}[/latex]
Unlike marginal revenue, ordinarily, marginal cost changes as the firm produces a greater quantity of output. At first, marginal cost decreases with additional output, but then it increases with additional output. Again, note this is the same as we found in the module on production and costs.
Table 3 presents the marginal revenue and marginal costs based on the total revenue and total cost amounts introduced earlier. Themarginal revenuecurve shows the additional revenue gained from selling one more unit, as shown in Figure 3.
| Quantity | Total Revenue | Marginal Revenue | Total Cost | Marginal Cost | Profit |
|---|---|---|---|---|---|
| 0 | $0 | $4 | $62 | – | -$62 |
| 10 | $40 | $4 | $90 | $2.80 | -$50 |
| 20 | $80 | $4 | $110 | $2.00 | -$30 |
| 30 | $120 | $4 | $126 | $1.60 | -$6 |
| 40 | $160 | $4 | $138 | $1.20 | $22 |
| 50 | $200 | $4 | $150 | $1.20 | $50 |
| 60 | $240 | $4 | $165 | $1.50 | $75 |
| 70 | $280 | $4 | $190 | $2.50 | $90 |
| 80 | $320 | $4 | $230 | $4.00 | $90 |
| 90 | $360 | $4 | $296 | $6.60 | $64 |
| 100 | $400 | $4 | $400 | $10.40 | $0 |
| 110 | $440 | $4 | $550 | $15.00 | -$110 |
| 120 | $480 | $4 | $715 | $16.50 | -$235 |
In the raspberry farm example, marginal cost at first declines as production increases from 10 to 20 to 30 packs of raspberries. But then marginal costs start to increase, due to diminishing marginal returns in production. If the firm is producing at a quantity where MR > MC, like 40 or 50 packs of raspberries, then it can increase profit by increasing output.The reason issince the marginal revenue exceeds the marginal cost, additional output is adding more to profit than it is taking away. If the firm is producing at a quantity where MC > MR, like 90 or 100 packs, then it can increase profit by reducing output. The firm’s profit-maximizing level of output will occur where MR = MC (or at a level close to that point).
Figure 3. Marginal Revenues and Marginal Costs at the Raspberry Farm. For a perfectly competitive firm, the demand curves a horizontal line equal to the market price of the good, Since price doesn’t change with additional output, the demand curve is also the marginal revenue (MR) curve.The marginal cost (MC) curve is sometimes initially downward-sloping, but is eventually upward-sloping at higher levels of output as diminishing marginal returns kick in.The firm will maximize profit at the level of output where MR = MC. In the case of the raspberry farm, this occurs at 80 packs of strawberries.
In this example, the marginal revenue and marginal cost curves cross at a price of $4 and a quantity of 80 produced. If the farmer started out producing at a level of 60, and then experimented with increasing production to 70, marginal revenues from the increase in production would exceed marginal costs—and so profits would rise. The farmer has an incentive to keep producing. At a level of output of 80, marginal cost and marginal revenue are equal so profit doesn’t change. If the farmer then experimented further with increasing production from 80 to 90, he would find that marginal costs from the increase in production are greater than marginal revenues, and so profits would decline.
The profit-maximizing choice for a perfectly competitive firm will occur at the level of output where marginal revenue is equal to marginal cost—that is, where MR = MC. This occurs at Q = 80 in the figure.
Does Profit Maximization Occur at a Range of Output or a Specific Level of Output?
Table 1showed that maximum profit occurs at any output level between 70 and 80 units of output. But MR = MC occurs only at 80 units of output. How do we explain this slight discrepancy? As long as MR > MC. a profit-seeking firm should keep expanding production. Expanding production into the zone where MR < MC reduces economic profits. It’s true that profit is the same at Q = 70 and Q = 80, but it’s only when the firm goes beyond that level, that we see profits fall. Thus, MR = MC is the signal to stop expanding, so that is the level of output they should target.
Because the marginal revenue received by a perfectly competitive firm is equal to the price P, we can also write the profit-maximizing rule for a perfectly competitive firm as a recommendation to produce at the quantity of output where P = MC.
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Watch It
Watch this video to practice finding the profit-maximizing point in a perfectly competitive firm. Mr. Clifford reminds us that in a perfectly competitive market, the demand curve is a horizontal line, which also happens to be the marginal revenue. You can use the acronym MR. DARP to remember that marginal revenue=demand=average revenue=price. The ideal production point is the place where MR=MC.
Glossary
- marginal revenue:
- the additional revenue gained from selling one more unit of output
- profit:
- the difference between total revenues and total costs
- profit-maximizing rule for a perfectly competitive firm:
- produce the level of output where marginal revenue equals marginal cost
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FAQs
Profit Maximization in a Perfectly Competitive Market? ›
A perfectly competitive firm maximizes its profits at the point where its total cost curve intersects its total revenue curve. 15. Economic profit is equal to the difference between total revenues and economic costs.
What is the profit maximization in perfect competition? ›The profit-maximizing choice for a perfectly competitive firm will occur where marginal revenue is equal to marginal cost—that is, where MR = MC. A profit-seeking firm should keep expanding production as long as MR > MC.
How do you find profit in a perfectly competitive market? ›At any given quantity, total revenue minus total cost will equal profit. One way to determine the most profitable quantity to produce is to see at what quantity total revenue exceeds total cost by the largest amount.
What is the profit-maximizing rule for a firm in a perfectly competitive market quizlet? ›The profit-maximizing principle states that the optimal amount to sell is when MR = MC. For a firm in a perfectly competitive industry, price is equal to marginal revenue, or P = MR. So, we can restate the MR = MC condition as P = MC.
How a perfectly competitive firm decides to maximize its profit in the short run? ›To maximize profit, a short-run perfectly competitive firm will choose the profit maximization point where marginal cost equals marginal revenue. That's because when marginal revenue is higher than marginal cost, the firm can increase revenue by increasing output.
What is the rule for profit maximization? ›A manager maximizes profit when the value of the last unit of product (marginal revenue) equals the cost of producing the last unit of production (marginal cost).
What is an example of profit maximization? ›Examples of profit maximizations like this include: Find cheaper raw materials than those currently used. Find a supplier that offers better rates for inventory purchases. Find product sources with lower shipping fees.
How is profit maximized in perfect competition and monopoly? ›In a perfectly competitive market, price equals marginal cost and firms earn an economic profit of zero. In a monopoly, the price is set above marginal cost and the firm earns a positive economic profit. Perfect competition produces an equilibrium in which the price and quantity of a good is economically efficient.
Which of the following best describes the profit-maximizing rule for a perfectly competitive firm? ›The profit-maximizing condition for a perfectly competitive firm is to produce all units for which marginal revenue is equal to market price. This means that the firm will produce up to the point where the marginal revenue from the sale of an additional unit is equal to the market price.
What is the profit-maximizing condition for a perfect competitive firm is to sell the output level that makes? ›A firm's total profit is maximized by producing the level of output at which marginal revenue for the last unit produced equals its marginal cost, or MR = MC. In a perfectly competitive market, MR is equal to the market price P for all levels of output.
What two rules does a perfectly competitive firm apply to determine its profit-maximizing quantity of output? ›
What two rules does a perfectly competitive firm apply to determine its profit-maximizing quantity of output? A perfectly competitive firm will determine its profit-maximizing level of output on the basis of marginal cost and marginal revenue.
At what point does a perfectly competitive firm maximize profits or minimize loss? ›The profit-maximizing choice for a perfectly competitive firm will occur at the level of output where marginal revenue is equal to marginal cost—that is, where MR = MC.
What happens to profits in the long run in a perfectly competitive market? ›In a perfectly competitive market, firms can only experience profits or losses in the short run. In the long run, profits and losses are eliminated because an infinite number of firms are producing infinitely divisible, homogeneous products.
What are the three conditions of profit maximization? ›The cost price p, must be equal to MC. The marginal cost must be non-decreasing at q0. For the enterprise to continue to manufacture in the short run, the cost price must be greater than the average variable cost (p > AVC), whereas in the long run, the cost price must be greater than the average cost (p > AC).
What is profit maximization in simple words? ›Profit maximisation is a process business firms undergo to ensure the best output and price levels are achieved in order to maximise its returns. Influential factors such as sale price, production cost and output levels are adjusted by the firm as a way of realising its profit goals.
What are the three general rules for profit maximization for a competitive firm? ›-Three general rules for profit maximization:oIf marginal revenue is greater than marginal cost, the firm should increase itsoutput. oIf marginal cost is greater than marginal revenue, the firm should decrease itsoutput. oAt the profit-maximizing level of output, marginal revenue and marginal cost areexactly equal.
Why is profit Maximisation the most important? ›Think of it this way: a firm must make a profit in order to stay in business and remain competitive. Therefore, the money it brings in must be equal all its explicit costs (materials, labour and so on) plus the money needed to remain competitive (known as 'normal profit').
Who benefits from profit maximization? ›Benefits from aiming to maximise profits:
Shareholders are likely to benefit from higher dividends (a share of profits) Employees may gain if some part of their pay is linked to the profitability of the business.
What is Profit Maximization? Profit maximization is the process by which a business arranges its prices and cost structure to achieve the highest possible profit. The central goal of the organization is to increase its profits.
Where are total profits maximized? ›The profit maximization of a firm is achieved when its marginal revenue is equal to marginal cost of the additional unit of output.
What is the profit-maximizing condition for a business firm? ›
What is the profit maximization rule? The common rule for profit maximization is that firms should be able to produce enough goods and services to increase the marginal revenue. The marginal revenue should equal the marginal cost of goods and services.
When perfectly competitive firms are making an economic profit then? ›The economic profit in a perfectly competitive market determines whether new firms will enter the market in the long-run. Thus, it is the incentive for entry and exit in a perfectly competitive market. If the economic profit is positive, then we expect more firms to enter the market in the long-run.
How should a profit-maximizing firm choose their output? ›The profit-maximizing choice for the monopoly will be to produce at the quantity where marginal revenue is equal to marginal cost: that is, MR = MC. If the monopoly produces a lower quantity, then MR > MC at those levels of output, and the firm can make higher profits by expanding output.
What determines the profit-maximizing output for the firm? ›The monopolist's profit maximizing level of output is found by equating its marginal revenue with its marginal cost, which is the same profit maximizing condition that a perfectly competitive firm uses to determine its equilibrium level of output.
What does a profit-maximizing firm set its price to? ›At the profit maximizing quantity (QT), the monopolist sets price equal to P, found by plugging QT into the consumers' willingness to pay, or the demand curve (D). To find the quantity to produce in each plant, the firm sets MC 1 = MC 2 = MC T to find the profit-maximizing level of output in each plant: Q 1 and Q 2.
What prevents a perfectly competitive firm from seeking higher profits? ›What prevents a perfectly competitive firm from seeking higher profits by increasing the price that it charges? Perfect competitive firm can't charge higher price to seek higher profits due to : Constant price, perfectly elastic demand, and normal profits in long run.
What is the second order condition for profit maximization in a perfectly competitive market? ›Profit maximization arises with regards to an input when the value of the marginal product is equal to the input cost. A second characteristic of a maximum is that the second derivative is negative (or nonpositive). This property is known as the second-order condition.
Which of the following statements relating to a profit-maximizing perfectly competitive firm is true? ›The profit-maximizing perfectly competitive firm will produce up to the point where the price of its output is just equal to short-run marginal cost. True: Firms maximize profits by producing a quantity where marginal revenue is equal to marginal cost.
Is it possible for a perfectly competitive firm to be maximizing profits but not achieving resource allocative efficiency? ›In conclusion, a perfectly competitive firm can be maximizing profits, but not achieving resource allocative efficiency if the market price is not equal to the marginal cost of production. This can happen due to externalities or market imperfections.
What do profits in a perfectly competitive industry equal in long run equilibrium? ›The existence of economic profits attracts entry, economic losses lead to exit, and in long-run equilibrium, firms in a perfectly competitive industry will earn zero economic profit.
How is profit and output determined under perfect competition? ›
How Price and Output is Determined Under Perfect Competition? In perfect competition, price and output are determined by the interaction of demand and supply in the market. These forces decide the price of the industry. The firms will follow the prices decided by the forces of demand and supply.
How do you calculate profit? ›Profit is simply total revenue minus total expenses. It tells you how much your business earned after costs. Since the primary goal of any business is to earn money, profit is a clear indication of how your company is functioning and performing in the market.
How to calculate profit-maximizing output in perfect competition from a table? ›Simply calculate the firm's total revenue (price times quantity) at each quantity. Then subtract the firm's total cost (given in the table) at each quantity.
What happens in a perfectly competitive industry when firms earn profits? ›Under perfect competition, there are many buyers and sellers, and prices reflect supply and demand. Companies earn just enough profit to stay in business and no more. If they were to earn excess profits, other companies would enter the market and drive profits down.
Are profits always positive in perfect competition? ›Under conditions of perfect competition, all firms make positive economic profits.
What is the formula for profit-maximizing level of output? ›The rule of profit maximization in a world of perfect competition was for each firm to produce the quantity of output where P = MC, where the price (P) is a measure of how much buyers value the good and the marginal cost (MC) is a measure of what marginal units cost society to produce.
What is the profit maximization pricing? ›Profit-maximization pricing means setting prices so that total revenue is as large as possible relative to total costs. This is the prime pricing strategy to use if you are in a monopoly.
Why is MC MR profit-maximizing? ›The marginal revenue is the additional revenue added by increasing the quantity. This is also known as the additional revenue “at the margin.” Therefore, profit is maximized when marginal cost equals marginal revenue which is the same as saying when marginal profit equals zero.
What are the 2 formulas for profit? ›| Formula for Profit | Profit = S.P – C.P. |
|---|---|
| Formula for Profit Percentage | Profit Percent Formula = P r o f i t × 100 C . P . |
| Gross Profit Formula | Gross Profit = Revenue – Cost of Goods Sold |
| Profit Margin Formula | Profit Margin = T o t a l I n c o m e N e t S a l e s × 100 |
Net profit margin is calculated by dividing earnings after taxes (EAT) by net revenue, and multiplying the total by 100%. The higher the ratio, the more cash the company has available to distribute to shareholders or invest in new opportunities.
What is the formula for profit profitability? ›
= Gross profit / Net sales * 100.