Question

1. a. Define the terms “Marginal Revenue” and “Marginal Cost”.

     b. Illustrate and explain in detailhow a perfectly competitive firm uses MR and

         MC to identify its profit-maximizing output.

     c. Once a firm has identified its profit-maximizing output, will the firm necessarily

         be earning economic profit at that output? Explain in detail.

     d. Explain how a firm uses Average Revenue and Average Total Cost to determine

         the level of profit that it earns.

     e. Is it possible for a firm to incur economic losses while producing its profit-

        maximizing output? Explain.

Answer 1

Part A

Marginal Revenue

The additional revenue generated by selling one more unit of output is called as Marginal revenue (MR). It is the slope of demand curve

Marginal Cost

The additional cost that is incurred when producing an additional unit of output is called Marginal Cost (MC)

Part b

Inorder to maximize profit in a perfectly competitive market, firms set marginal revenue and marginal cost equal (MR = MC). Under perfect competition MR curve equald the deman curve equals price i.e. AR = MR = P.

Thus under a perfect competition the demand curve is perfectly elastic i.e. any amount of output can be supplied at this price. Because there are large numbers of buyers and sellers thus it was a price taking market and thus price was equal to marginal cost ( P=MC)

So at profir maximization level of output MR = MC

And we know that P = MC

Thus P = MR = MC is the profit maximization level of output.

Part c

We must note that at the profit max level of output, in the short run firms can earn positive, negitive or no economic profits while in the long run it is that they would earn zero economic profits.

So we will see that in the short run if there are positive profits in the market then new firms would enter in the market. This would lead to increase in the supply which would lower the price and wipe off the profits. Thus in the long run they will earn zero profit .

Similarly if firms are having losses in the short run then some of the firms would leave the market which will lead to decrease in suppy and it will shoot the prices up thus giving zero economoc profit.

So in the long run firms will earn zero economic profits.

So when proces are greater than average total cost then firms are earning profits in the market while if it is less than ATV then they are incurring losses.

Part d

We must note that for a perfectly competitive market the breakeven condition occurs when AR = ATC

If AR > ATC then there are positive profits in the market. On the other hand there would be losses if AR < ATC.

Part e

Yes it is possible for a firm to produce at profit maximum point and still earns an economic loss. It means that at any other point there would be more loss to a firm and the least loss would occur at a profit maximization point