Question

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

Short answer

In a perfectly competitive market, a firm determines its profit-maximizing quantity of output by following two rules: (1) Produce the level of output where Marginal Cost (MC) equals Marginal Revenue (MR), represented by \(MC = MR\), and (2) Produce the level of output where the Price (P) equals Marginal Cost (MC), represented by \(P = MC\).

Step-by-step solution

Understanding Perfect Competition

Perfect competition is a market structure characterized by a large number of small firms, identical products, perfect information, and no barriers to entry or exit. In this market, firms are price takers, which means they do not have the power to set prices; instead, they take the market price as given. The goal of the firm in a perfectly competitive market is to maximize its profit.

Rule 1: Marginal Cost Equals Marginal Revenue

The first rule for a perfectly competitive firm to determine its profit-maximizing quantity of output is that the firm will produce the level of output where its marginal cost (MC) equals its marginal revenue (MR). Mathematically, this rule can be expressed as: \(MC = MR\) Marginal cost is the additional cost incurred from producing one more unit of output, while marginal revenue is the additional revenue earned from selling one more unit of output. By equalizing MC and MR, the firm ensures that it is choosing the level of output that maximizes the difference between total revenue and total cost, therefore maximizing profit.

Rule 2: Price Equals Marginal Cost

The second rule for a perfectly competitive firm to determine its profit-maximizing quantity of output is that the firm will produce the level of output where the price equals its marginal cost (MC). Mathematically, the rule can be expressed as: \(P = MC\) In a perfectly competitive market, the firm's marginal revenue equals the market price, as changes in the firm's production do not affect the market price. So applying the first rule, where \(MC = MR\), we find: \(MC = P\) By producing the level of output where the price equals marginal cost, the firm ensures that it is not leaving any potential profit on the table. Producing more output would result in a higher marginal cost than the price received for that additional unit, thus reducing profit. Conversely, producing less output would have a lower marginal cost than the price received, leaving potential profit unexploited.