Question

How does a perfectly competitive firm decide what price to charge?

Short answer

A perfectly competitive firm does not decide the price to charge for its product independently; it accepts the market price determined by the interaction of market demand and supply. The firm maximizes its profit by producing the output level where its marginal cost (MC) equals the market price. The firm's decision to continue operating depends on its costs and the market price, with break-even occurring when the market price equals the average total cost (ATC).

Step-by-step solution

Understanding the basic pricing decision for a perfectly competitive firm

In a perfectly competitive market, firms are price takers. This means that they cannot set the price of their product - they have to accept the market price. The market price is determined by the interaction of market demand and supply.

Analyzing the costs

In order to maximize profit, a perfectly competitive firm needs to analyze its cost structure, including its marginal cost (MC), average total cost (ATC), and average variable cost (AVC). The relationship between these costs will determine the firm's optimal output level.

Profit maximization

A perfectly competitive firm maximizes its profit by producing the level of output where its marginal revenue (MR) equals its marginal cost (MC). Since the firm is a price taker, its marginal revenue equals the market price. The optimal output level, therefore, is determined by solving the equation MR = MC.

Determining the break-even point

The break-even point occurs when the firm's total revenue is equal to its total cost (TR = TC). At the break-even point, the firm earns zero economic profit. To determine the break-even point, the firm needs to find the output level where the average total cost (ATC) is equal to the market price.

Decision-making process for firms

If the market price is above the firm's average total cost, the firm will make a positive economic profit. However, if the market price is below the firm's average variable cost (AVC), the firm will incur losses and may decide to shut down production temporarily. If the market price falls between the firm's average total cost (ATC) and average variable cost (AVC), the firm will operate at a loss, but will continue producing as long as it can cover its variable costs. In summary, a perfectly competitive firm does not decide the price it charges for its product independently; it accepts the market price determined by the interaction of market demand and supply. The firm maximizes its profit by producing the output level where its marginal cost equals the market price and makes a decision on whether to continue operating based on its costs and the market price.