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Profit Maximization in Perfect Competition
Explain how a firm maximises its profit in perfect competition.
Market Structures and Competition
[CIE A level November 2019]
Step ➊: Define ‘perfect competition’ and ‘profit maximisation’ the introduction.
Perfect competition is an ideal market structure that has many buyers and sellers, identical or homogeneous products, no barriers to entry. The main aim of perfectly competitive firms is to maximise profit. This can be achieved by producing at the profit maximising output where marginal revenue is equal to marginal cost as explained below.
Step ➋ : Explain how perfectly competitive firms maximise profit
➤ 2.1 Firms will produce where MR=MC in perfectly competitive firms.
It is assumed that perfectly competitive firms will seek to maximise their profits. They will aim to maximise the difference between the total revenue and total cost. A perfectly competitive firm will thus produce at the profit maximising output where marginal revenue is equal to marginal cost ( MR=MC ). This means that the firm produces up to the point where the cost of making the last unit is just covered by the revenue from selling it.
➤ 2.2 In perfectly competitive markets, D = AR = MR
It should be noted that perfectly competitive firms are price takers and will sell only at the ruling price P. If the firm sells an additional unit of output, it will get the same price as the one before. Thus marginal revenue is equal to the price or the average revenue (D = AR = MR ).
The perfectly competitive firm will operate at output Q where MC= MR both in the short run and the long run. This is shown in figure A and figure B.
➤ 2.3 Explain what happens if MR > MC or MR < MC
If the firm produces less than an output of Q, MR is greater than MC. Therefore, for this extra output, the firm is gaining more revenue than it is paying in costs, and total profit will increase. Then, if marginal revenue is greater than marginal cost at some level of output, marginal profit is positive and thus a greater quantity will be produced by the firm. By contrast, after the output of Q, the marginal cost of the output is greater than the marginal revenue. This means the firm will see a fall in its profit level because the cost of these extra units is greater than revenue. If marginal revenue is less than marginal cost, marginal profit is negative and a lesser quantity will be produced by the firm.
➤ 2.4 Explain the difference between profit in the short run and profit in the long run in a perfectly competitive market.
In the short run, the firm will be making an abnormal profit. Abnormal profit is represented by the shaded area in figure A. In the long run, new firms will enter the market since there are no barriers to entry and the abnormal profit will diminish. The firm will be only making normal profit at output Q in the long run.
Step ➌ : Conclude.
To conclude, a perfectly competitive firm will maximise its profit by producing where marginal revenue is equal to marginal cost. In the short run, the perfectly competitive firm will make abnormal profits whereas, in the long run, the firm will make normal profits.
♕ Marking scheme
An explanation of the profit maximising rule based on MC = MR. Explanation of how when MC and MR are unequal a firm changes its level of output to increase profits.
L4 (9–12 marks): For a sound explanation of increasing output when MC is less than MR and reducing output when MC is greater than MR to bring equilibrium when MC = MR.
L3 (7–8 marks): For an explanation of equilibrium increasing output when MC is less than MR or reducing output when MC is greater than MR to bring equilibrium when MC = MR.
L2 (5–6 marks): For an explanation of equilibrium when MC = MR.
L1 (1–4 marks): For an answer which has some basic correct facts but includes irrelevancies. Errors of theory or omissions of analysis will be substantial.