Just like other firms, competitive firms desire to maximise profit. Remember that rational people make decisions at the margin. Everyone, from individuals to firms to societies, maximises wellbeing by following a general decision-making rule:
Do anything as long as marginal benefit is greater than or equal to marginal cost.
· The corollary to this rule is that firms maximise profit by comparing marginal revenue and marginal cost.
- For the competitive firm, marginal revenue is fixed at the price of the good and marginal cost is increasing as output rises.
- Note that fixed costs are irrelevant for making future decisions. Economists refer to fixed costs as sunk costs, because once they are incurred they cannot be recovered. A firm determines how much output to produce by equating marginal revenue and marginal cost, neither of which is affected by fixed cost.
· The profit-maximising firm needs to consider the following revenue measures:
Average revenue = Total revenue / Quantity
Marginal revenue = ∆Total revenue / ∆Quantity where ∆ = 'change in'.
· For the competitive firm, all sales occur at the market price, which does not change as the firm increases output. As a result, in perfect competition:
Average revenue = Marginal revenue = Price
· Hence to maximise profit using marginal analysis, the perfectly competitive firm produces until:
Marginal revenue = Price = Marginal cos
There are three general rules for profit maximisation:
1. If marginal revenue exceeds marginal cost, the firm should increase output to increase profit.
2. If marginal cost exceeds marginal revenue, the firm should decrease output to increase profit.
3. At the profit maximising level of output, marginal revenue and marginal cost are exactly equal.
From these three general rules we can see that at any price level, the firm will choose the quantity supplied by looking at the marginal cost curve, remembering that marginal revenue equals price in perfect competition. That is, the firm's marginal cost curve determines how much the firm is willing to supply at any price. This makes the marginal cost curve the firm's supply curve. The only qualification is that firms will not sell at a price below average variable cost. If price is below average variable cost, the firm is losing more money than if it were to shut down. Therefore, the competitive firm's supply curve in the short run is the portion of its marginal cost curve that lies above the average variable cost curve.
The shutdown rule:
In the short run, the firm shuts down if P < AVC (or if TR < TVC)
The analysis is similar in the long run, except that all costs are variable. Remember that in the long run all inputs and costs are variable. Consequently, the profit-maximising firm in the long run will not produce below average total cost (ATC). With P < ATC, the firm is incurring losses and will go out of business. On the other hand, if P > ATC, the firm will earn an economic profit, encouraging it to stay in business and encouraging other firms to enter the industry. The competitive firm's long run supply curve is the portion of its marginal cost curve that lies above its average total cost curve.
The exit rule:
In the long run, the firm exits if P < ATC (or if TR < TC)
Keep in mind the difference between economic and accounting profit. Economic profit includes all opportunity costs of time and capital. When a firm has zero economic profit it is enjoying a normal accounting profit. It is for this reason that firms are willing to continue to produce at a point of zero economic profit. In addition, any positive economic profit provides an incentive for firms to enter the industry