Question

At what level of output is profit maximized for a perfectly competitive firm? Why will the firm not produce this level of output? Explain

Answer 1

Answer: The producer’s equilibrium can be understood in terms of marginal revenue (MR-- it is the additional revenue generated by increasing sales and it is TR= MRn- MRn-1) and marginal cost (MC- it is the addition of total cost)of production. Profit is maximized (or a producer strikes his equilibrium) by following ways:

(i) MR = MC, and (ii) MC is rising (or MC is greater than MR beyond the point of equilibrium output). Let us understand the significance/rationale of these conditions with reference to Table 1.

In Table 1, MR = MC in two situations – (i) when 2 units of output are produced, and (ii) when 10 units of output are produced. However, while in situation 1 (when output = 2 units) MC is falling, in situation 2 (when output = 10 units) MC is rising. A producer will strike his equilibrium only when MC is rising.

Implying that the equilibrium will be struck when 10 units of output are produced, not when 2 units of output are produced. The reason is simple. Given the price, falling MC only increases the difference between TR and TVC (recall, ΣMC = TVC, and ΣMR = TR). So that TR – TVC tends to rise, or that profits tend to rise in a situation of falling MC.

Accordingly, it would be an irrational decision for a producer to strike his equilibrium in a situation of falling MC. It is only when MC is rising that a producer would strike his equilibrium. Thus, equilibrium will be struck when MR = MC = 12, and MC is rising. The producer will maximize profits when 10 units of output are produced.