Question

Todd is trying to remember what he learned in introductory microeconomics, but he keeps getting confused. This thinking is as follows:

Firms produce where MR=MC, which means that the money they bring in (revenue) is equal to their costs. This is a little weird though because if revenue equals cost, the firm doesn’t make profit. Even though it doesn’t seem to match the real world, Todd thinks this may be correct because he learned that in perfect competition, firms make zero economic profit. Still, it seems that it would make more sense to produce where revenue is larger than cost and that way firms could make a profit?

In a few paragraphs, explain to Todd where he is going wrong. Be sure to correct all of his mistakes.  

Answer 1

The MR = MC is short run equilibrium condition for firms in perfectly competitive market structure. It is only a necessary condition not sufficient, to explain it further consider the following figure

At point K, MR = MC but the firm cannot just continue production at that level because beyond the point MR is greater than MC so the firm has an incentive to produce more. Now, if the firm keeps on raising the production level , a point will come like point E in the figure where not only MR = MC, but also production beyond that will raise cost not revenue.

Todd is wrong to believe that at the point of equilibrium profit is zero , actually profit is normal and Economic profits are zero. Firms are making profit that's why they remain in business. If some firms exit the industry others earn super normal profit for a time but that also is absorbed over a long period of time.