Question

- Perfect Competition

A. State the short-run profit maximizing rule for a firm and explain why it ensures that profits are maximized.

B. State the condition under which a competitive firm will go out of business (i.e., shutdown) and explain why it will do so.

Answer 1

A.

Short run profit maximizing rule is:

MR = MC

An output level produced when MR = MC, will give maximum profit. It will ensure profit maximization, because afterwards, with each additional output to be produced, marginal cost will increase and it will become more than the marginal revenue earned. So, erosion in total net profit will start.

Even if the firm produces at the level, when MR > MC, then firm is not utilizing its capacity to maximize the profit. Hence, firm should produce at a level, when MR = MC

B.

When, Price (MR) goes to be less than the average variable cost, the firm should shutdown and go out of the market. It is the time to shut down, because, with each unit sold, the firm is increasing its losses as marginal revenue or price received is less than the average variable cost incurred. Hence, it is the right decision to go out of the market in the short run.

In the long run, where all factors of production are variable, if price is less than the ATC, then firm should shut down, because firm cannot earn profit in this market.