How Perfectly Competitive Firms Make Output Decisions
A perfectly competitive firm
has only one major decision to make—namely, what quantity to produce. To understand why this is so, consider a different way of writing out the basic definition of profit:
| Profit | = Total Revenue – Total Cost |
| = (Price)(Quantity Produced) – (Average Cost)(Quantity Produced) |
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. Total revenue is going to increase as the firm sells more, depending on the price of the product and the number of units sold. If you increase the number of units sold at a given price, then total revenue will increase. If the price of the product increases for every unit sold, then total revenue also increases. 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.
Total revenue and total costs for the raspberry farm, broken down into fixed and variable costs, are shown in Table 8.1 and also appear in Figure 8.2. 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 covered in the Cost and Industry Structure module.
Figure 8.2. Total Cost and Total Revenue at the Raspberry Farm. Total revenue for a perfectly competitive firm is a straight line sloping up. The slope is equal to the price of the good. Total cost also slopes up, but with some curvature. At higher levels of output, total cost begins to slope upward more steeply because of diminishing marginal returns. The maximum profit will occur at the quantity where the gap of total revenue over total cost is largest.
Table 8.1 Total Cost and Total Revenue at the Raspberry Farm
| Quantity
(Q) |
Total Cost
(TC) |
Fixed Cost
(FC) |
Variable Cost
(VC) |
Total Revenue
(TR) |
Profit |
|---|---|---|---|---|---|
| 0 | $62 | $62 | – | $0 | −$62 |
| 10 | $90 | $62 | $28 | $40 | −$50 |
| 20 | $110 | $62 | $48 | $80 | −$30 |
| 30 | $126 | $62 | $64 | $120 | −$6 |
| 40 | $144 | $62 | $82 | $160 | $16 |
| 50 | $166 | $62 | $104 | $200 | $34 |
| 60 | $192 | $62 | $130 | $240 | $48 |
| 70 | $224 | $62 | $162 | $280 | $56 |
| 80 | $264 | $62 | $202 | $320 | $56 |
| 90 | $324 | $62 | $262 | $360 | $36 |
| 100 | $404 | $62 | $342 | $400 | −$4 |
Based on its total revenue and total cost curves, a perfectly competitive firm like the raspberry farm can calculate the quantity of output that will provide the highest level of profit. At any given quantity, total revenue minus total cost will equal profit. One way to determine the most profitable quantity to produce is to see at what quantity total revenue exceeds total cost by the largest amount. On Figure 8.2, the vertical gap between total revenue and total cost represents either profit (if total revenues are greater that total costs at a certain quantity) or losses (if total costs are greater that total revenues at a certain quantity). In this example, total costs will exceed total revenues at output levels from 0 to 40, and so over this range of output, the firm will be making losses. At output levels from 50 to 80, total revenues exceed total costs, so the firm is earning profits. But then at an output of 90 or 100, total costs again exceed total revenues and the firm is making losses. Total profits appear in the final column of Table 8.1. The highest total profits in the table, as in the figure that is based on the table values, occur at an output of 70–80, when profits will be $56.
A higher price would mean that total revenue would be higher for every quantity sold. A lower price would mean that total revenue would be lower for every quantity sold. What happens if the price drops low enough so that the total revenue line is completely below the total cost curve; that is, at every level of output, total costs are higher than total revenues? In this instance, the best the firm can do is to suffer losses. But a profit-maximizing firm will prefer the quantity of output where total revenues come closest to total costs and thus where the losses are smallest.
(Later we will see that sometimes it will make sense for the firm to shutdown, rather than stay in operation producing output.)
Watch the following video to learn more about the point of profit maximization.