Question

What two rules does a perfectly competitive firm apply to determine its profit-maximizing quantity of output?

Short answer

A perfectly competitive firm applies the following two rules to determine its profit-maximizing quantity of output: 1. Produce at the output level where Marginal Revenue (MR) equals Marginal Cost (MC), i.e., \(MR = MC\). 2. In a perfectly competitive market, Price (P) equals Marginal Cost (MC), i.e., \(P = MC\).

Step-by-step solution

Rule 1: Marginal Revenue (MR) Equals Marginal Cost (MC)

In a perfectly competitive market, a firm maximizes its profit by producing an output level where marginal revenue (MR) equals marginal cost (MC). Mathematically, the rule can be represented as: \[MR = MC\] Marginal revenue is the additional revenue a firm earns from selling one more unit of a good or service, while marginal cost represents the additional cost incurred by the firm to produce that additional unit. When marginal revenue is equal to marginal cost, the firm has maximized its profits because it is earning the most revenue for the least additional cost.

Rule 2: Price (P) Equals Marginal Cost (MC)

In a perfectly competitive market, firms are price-takers, meaning that they cannot influence the market price of the goods or services they sell. Hence, the price (P) they receive for each unit sold is always equal to the marginal revenue they earn from selling that unit: \[P = MR\] Since we already know that, under perfect competition, a firm maximizes profit when MR equals MC, we can conclude that the firm must also set its output level at the point where price equals marginal cost: \[P = MC\] By applying both of these rules – MR equals MC and price equals MC – a perfectly competitive firm can determine its profit-maximizing quantity of output.