7.2 How Perfectly Competitive Firms Make Output Decisions
7.2 How Perfectly Competitive Firms Make Output Decisions
Learning Objectives
By the end of this section, you will be able to:
- Calculate profits by comparing total revenue and total cost
- Identify profits and losses with the average cost curve
- Explain the shutdown point
- Determine the price at which a firm should continue producing in the short run
A perfectly competitive firm has only one major decision to make—namely, what quantity to produce. To understand this, consider a different way of writing out the basic definition of profit:
Since a perfectly competitive firm must accept the price for its output as determined by the product’s market demand and supply, it cannot choose the price it charges. This is already determined in the profit equation, and so the perfectly competitive firm can sell any number of units at exactly the same price. It implies that the firm faces a perfectly elastic demand curve for its product: buyers are willing to buy any number of units of output from the firm at the market price. When the perfectly competitive firm chooses what quantity to produce, then this quantity—along with the prices prevailing in the market for output and inputs—will determine the firm’s total revenue, total costs, and ultimately, level of profits.
Determining the Highest Profit by Comparing Total Revenue and Total Cost
A perfectly competitive firm can sell as large a quantity as it wishes, as long as it accepts the prevailing market price. The formula above shows that total revenue depends on the quantity sold and the price charged. If the firm sells a higher quantity of output, then total revenue will increase. If the market price of the product increases, then total revenue also increases whatever the quantity of output sold. As an example of how a perfectly competitive firm decides what quantity to produce, consider the case of a small farmer who produces raspberries and sells them frozen for $4 per pack. Sales of one pack of raspberries will bring in $4, two packs will be $8, three packs will be $12, and so on. If, for example, the price of frozen raspberries doubles to $8 per pack, then sales of one pack of raspberries will be $8, two packs will be $16, three packs will be $24, and so on.
Table 7.1 shows total revenue and total costs for the raspberry farm, these also appear graphically in Figure 7.2. The horizontal axis shows the quantity of frozen raspberries produced in packs. The vertical axis shows both total revenue and total costs, measured in dollars. The total cost curve intersects with the vertical axis at a value that shows the level of fixed costs, and then slopes upward. All these cost curves follow the same characteristics as the curves that we covered in the Production, Costs and Industry Structure chapter.
| Quantity
(Q) |
Total Cost
(TC) |
Total Revenue
(TR) |
Profit |
| 0 | $62 | $0 | −$62 |
| 10 | $90 | $40 | −$50 |
| 20 | $110 | $80 | −$30 |
| 30 | $126 | $120 | −$6 |
| 40 | $138 | $160 | $22 |
| 50 | $150 | $2