Question

Each of the following describes the situation currently faced by a perfectly competitive firm. In each situation, determine the firm's profit and whether the firm is maximizing profit. If the firm is not maximizing profit, determine how the firm must respond to increase its profit.

a. P=$5, Q=500, TVC = $1500, AFC = $1, MC=AVC

b. AR = $10, Q=100, TC = $2000, TVC=$1500, MC = $10

Answer 1

(a)

TVC = $1,500

Q = 500

AVC = TVC/Q = 1,500/500 = 3

AVC = MC

So,

MC = $3

A perfectly competitive firm maximizes profit when it produce that level of output corresponding to which price equals marginal cost.

In given case,

P = $5

MC = $3

So, in given case, at current level of output, price is not equal MC.

Thus,

The firm is not maximizing profit.

As price is greater than the marginal cost, firm should increase production.

Thus,

The firm should increase production to increase profit.

AFC = $1

TFC = AFC * Q = $1 * 500 = $500

TVC = $1,500

TC = TFC + TVC = $500 + $1,500 = $2,000

TR = P * Q = $5 * 500 = $2,500

Calculate Profit -

Profit = TR - TC = $2,500 - $2,000 = $500

Thus,

The firm's profit is $500.

(b)

AR = $10

AR always equals price.

So,

Price, P = $10

MC = $10

A perfectly competitive firm maximizes profit when it produce that level of output corresponding to which price equals marginal cost.

In given case,

P = MC

Thus,

The firm is maximizing profit.

TR = P * Q = $10 * 100 = $1,000

TC = $2,000

Calculate profit -

Profit = TR - TC = $1,000 - $2,000 = -$1,000

Thus,

The firm's profit is -$1,000.