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Course: Microeconomics > Unit 7
Lesson 1: Perfect competition- Introduction to perfect competition
- Perfect competition and why it matters
- Economic profit for firms in perfectly competitive markets
- How perfectly competitive firms make output decisions
- Efficiency in perfectly competitive markets
- Perfect competition foundational concepts
- Long-run economic profit for perfectly competitive firms
- Long-run supply curve in constant cost perfectly competitive markets
- Long run supply when industry costs aren't constant
- Free response question (FRQ) on perfect competition
- Perfect competition in the short run and long run
- Increasing, decreasing, and constant cost industries
- Efficiency and perfect competition
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How perfectly competitive firms make output decisions
See examples of how perfectly competitive firms decide how much to produce.
Key points
- As a perfectly competitive firm produces a greater quantity of output, its total revenue steadily increases at a constant rate determined by the given market price.
- Profits will be highest—or losses will be smallest—for a perfectly competitive firm at the quantity of output where total revenues exceed total costs by the greatest amount, or where total revenues fall short of total costs by the smallest amount.
How perfectly competitive firms make output decisions
A perfectly competitive firm has only one major decision to make—what quantity to produce. To understand why this is so, let's 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. In other words, the price is already determined in the profit equation, so the perfectly competitive firm can sell any number of units at exactly the same price.
This 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 which quantity to produce, 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. If a firm increases 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. The sale 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 are shown in the graph below; these numbers are further broken down into fixed costs and variable costs in the table that follows the graph. The horizontal axis of the graph 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.
| Quantity, | Total cost, | Fixed cost, | Variable cost, | Total revenue, | 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. In the graph above, 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, 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.
You can also find the highest profit by looking at the table above where total profits appear in the final column. The highest total profits in the table—as in the figure that is based on the table values—occur at an output of 70 to 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 would happen if the price dropped low enough so that the total revenue line is completely below the total cost curve—in other words, total costs were higher than total revenues at every level of output? In that situation, the best the firm could do would be 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.
Summary
- As a perfectly competitive firm produces a greater quantity of output, its total revenue steadily increases at a constant rate determined by the given market price.
- Profits will be highest—or losses will be smallest—for a perfectly competitive firm at the quantity of output where total revenues exceed total costs by the greatest amount, or where total revenues fall short of total costs by the smallest amount.
Self-check questions
Using the data in the table below, determine what would happen to this firm’s profits if the market price of their product increased to $6.
| Quantity | Total cost | Fixed cost | Variable cost | Total revenue | Profit |
|---|---|---|---|---|---|
| 0 | $62 | $62 | - | $0 | −$62 |
| 10 | $90 | $62 | $28 | $60 | −$30 |
| 20 | $110 | $62 | $48 | $120 | $10 |
| 30 | $126 | $62 | $64 | $180 | $54 |
| 40 | $144 | $62 | $82 | $240 | $96 |
| 50 | $166 | $62 | $104 | $300 | $134 |
| 60 | $192 | $62 | $130 | $360 | $168 |
| 70 | $224 | $62 | $162 | $420 | $196 |
| 80 | $264 | $62 | $202 | $480 | $216 |
| 90 | $324 | $62 | $262 | $540 | $216 |
| 100 | $404 | $62 | $342 | $600 | $196 |
Review questions
- How does a perfectly competitive firm decide what price to charge?
- What prevents a perfectly competitive firm from seeking higher profits by increasing the price that it charges?
- How does a perfectly competitive firm calculate total revenue?
Critical-thinking questions
- Your company operates in a perfectly competitive market. You have been told that advertising can help you increase your sales in the short run. Would you create an aggressive advertising campaign for your product?
- Since a perfectly competitive firm can sell as much as it wishes at the market price, why can the firm not simply increase its profits by selling an extremely high quantity?
Want to join the conversation?
In the self-check question, isnt the price already at 6 dollars? Why would the profits increase then? Is it because at the new market price they would sell bigger quantities of their product?(12 votes)
What's the answer to the first critical-thinking question? If I created an aggressive advertising campaign, perhaps my extra sales would hurt competitors and push them out of the market. However, the question was clear in that advertising would only increase sales in the short run.(4 votes)
Creating an aggressive advertising campaign for your product may increase your sales as well as the sales of your competitors, given that the products are identical. I believe it will be more beneficial to your competitors as it will not cost them anything, but however, will add to your TC.(15 votes)
- what's the answer for the second review question?why does it become unprofitable to just increase production as much as possible?(1 vote)
- As the other commenters have implied, we also need to consider costs. At some point, the cost of production will become large enough to surpass the additional revenue gained by more production. In the raspberry example, imagine producing more and more raspberries until more farmland is needed - at some point the cost to produce an additional production will outweigh the additional revenue gained from an additional product.(3 votes)
- "If the price of the product increases for every unit sold, then total revenue also increases." I believe this is an incorrect statement because the demand in a perfectly competitive market is perfectly elastic, meaning that even a slight increase in the price will bring down total revenue.(0 votes)
- How does shut down price guide a firm in its decision whether to continue to operate or make exit in case the firm under perfectly competitive market in the short run incurs loses?(0 votes)
In this case, you calculate profit by subtracting Total Cost from Total Revenue, but we've also seen profit being calculated from the subtraction of two surfaces from the graph. The difference is that, in this case, we have Total Cost/Total Revenue for the vertical axis, while in the other example we would have the Cost/Revenue per unit. My question is, what's the mathematical operation that gets us from one to another? Do we integrate to obtain Total Cost/Total Revenue and derive to obtain Cost/Revenue per unit again?(0 votes)