Question

A. Why is the equality of marginal revenue and marginal cost essential for profit maximization in all market structures?

B. Explain why price can be substituted for marginal revenue in the MR=MC rule when an industry is purely competitive

Answer 1

Answer:-

As we know that each firm wants an extra unit of output to add more to the revenue than to the cost. When the extra unit of output produced and sold adds more to revenue in comparison to cost, it becomes profitable for the firm to produce that unit. On the other hand, if an extra unit of output produced and sold adds more to cost in comparison to revenue, it means losses to a firm.

So, every firm wants to increase its production until marginal revenue keeps exceeding the marginal cost because this means the increase in profit.

This increase in profit keeps happening until marginal revenue becomes equal to marginal cost because after that marginal cost exceeds the marginal revenue and profit starts declining.

So, the firm makes maximum profit at the level of output where MC equals the MR because below that level of output profit can be increased further whereas above that level of output, profit starts declining or losses starts accruing.

Therefore, the equality of marginal revenue and marginal cost is essential for the profit maximization in all market structure.

In purely competitive industry price equals MR.

This happens because the firm in a purely competitive industry is a price taker and can sell as much as it can at the given price and thus each additional unit sold by the firm increases the total revenue of the firm by the amount of the price.

As we know that change in total revenue is marginal revenue and as total revenue is changing by the amount of price, therefore, price equals the marginal revenue under perfectly competitive market. Therefore, due to this equality of P and MR price can be substituted for marginal revenue in the MR=MC rule when an industry is purely competitive.