Question

If it is possible for a perfectly competitive firm to do better financially by producing rather than shutting down, then it should produce the amount of output at which: LO10.5 a. \(\mathrm{MR}<\mathrm{MC}\) b. \(\mathrm{MR}=\mathrm{MC}\) c. \(\mathrm{MR}>\mathrm{MC}\) d. none of the above.

Short answer

A perfectly competitive firm should produce where \( MR = MC \).

Step-by-step solution

Understanding the Opportunity to Produce

First, we need to recognize when a perfectly competitive firm should opt to produce instead of shutting down. A firm will choose to produce if it can cover its variable costs in the short run, meaning price ( P ) must be greater than or equal to average variable cost ( AVC ). In this scenario, the firm should continue producing to at least cover its variable costs and potentially some of its fixed costs.

Using Marginal Analysis for Output Decisions

For a perfectly competitive firm, the profit-maximizing decision involves producing where marginal revenue ( MR ) is equal to marginal cost ( MC ). This critical point ensures that each additional unit of output generates exactly as much revenue as the cost to produce it. Decisions beyond this point would either not cover costs (if MC is greater) or forgo potential profits (if MR is greater).

Applying Marginal Revenue and Marginal Cost Relationship

In perfectly competitive markets, price ( P ) equals MR . So, the firm will continue producing where P = MR = MC . Option b, MR = MC , is the condition ensuring that the firm is maximizing its profit or minimizing its losses by producing the optimal output level because it is adjusting output so that the cost of producing an additional unit is exactly equal to the revenue it gains.

Key concepts

Marginal Revenue

Understanding marginal revenue is essential when analyzing the decisions made by a perfectly competitive firm. Marginal revenue (MR) is the additional income that a firm receives from selling one more unit of its product. In simpler terms, it tells the firm how much its revenue will increase with the sale of an additional unit.

In a perfectly competitive market, each firm is a price taker, meaning the price is determined by the market and is the same for every unit sold. Therefore, for such firms, the marginal revenue remains constant and equal to the market price. This characteristic simplifies profit-maximizing decisions, as it aligns directly with the pricing mechanism in the market. Marginal revenue plays a key role in determining how much a firm should produce:

• To maximize profits, firms aim to produce where marginal revenue equals marginal cost (MR = MC).
• If MR is greater than MC, the firm could increase profit by increasing production.
• If MR is less than MC, producing more would lead to a loss on those extra units.

Marginal Cost

Marginal cost (MC) is the increase in total cost that arises from producing one additional unit of output. For firms, understanding marginal cost is crucial in determining the optimal level of production. In a perfectly competitive environment, firms focus on where their costs meet or exceed revenues to guide production decisions.

• MC helps in identifying the point at which total costs for producing an additional unit are equal to the revenue (where MR = MC).
• This intersection is critical because producing beyond this point implies costs are higher than revenue gains, which effectively reduces profit.
• Conversely, if the MC is less than MR, the firm benefits from increasing production since each additional unit adds to overall profit.

Production decisions are shaped by closely monitoring marginal costs to ensure they align with the revenue generated by additional units. This ensures profitability remains intact, underlining the importance of efficiency in output levels.

Average Variable Cost

Average variable cost (AVC) is another fundamental concept for perfectly competitive firms. It represents the variable cost per unit of output produced. Variable costs, such as labor and materials, fluctuate with production changes and must be distinguished from fixed costs, which do not vary with output.

Knowing the AVC is crucial in determining whether a firm should continue operating in the short run:

• If market price (P) is greater than AVC, the firm should continue production because it can cover variable costs and contribute towards fixed costs.
• If P is less than AVC, it may be better to shut down as operating would lead to losses greater than fixed costs alone.

Understanding AVC helps firms evaluate their ability to sustain operations and maintain financial stability during varying market conditions. It serves as a key indicator of immediate production viability.