We discussed the idea that in

a competitive market a firm will set the quantity sold such that
price equals marginal cost. You might ask, well where did you
come up with that decision rule? So let's do a little calculus here to
understand why we have this decision rule that price should equal marginal cost
is where we should set our quantity. Consider the following profit function.
Profits equal simply revenues minus our
variable costs minus our fixed costs, variable cost being, again, the cost for
producing a certain number of goods, and the fixed cost being things we incur
even before we sell our first good. Mathematically, we represent it
using pi to represent profits. We have our revenues, which is our
price times the quantity sold. We represent variable cost simply
as a function of the quantity sold. So, C as a function of q1. And then we have our
fixed cost, represented by CEF which is basically
a fixed parameter within the model. So for those of you who have had calculus, you
might remember to maximize
an expression, an objective function. You take the derivative with respect
to the decision variable you have and you set it equal to zero. Now our decision
variable
here is the quantity sold. Once again, we are price takers. We are given the price
by the market. So we can just simply choose how many
t-shirts, in our t-shirt example, we are likely to sell. Here is the math, we take
the derivative,
set it equal to zero and what we find is, the derivative for the
revenue of piece, ends up being the price. We represent the derivative or
cost function or variable cost function as simply as the derivative of
the cost function with the c prime q1. The fixed costs fall out at this point,
and once again we set it to zero. Moving things around, we get P1 should
equal the derivative of our cost function. The derivative of our cost function, you
might recall, is simply our marginal
cost, hence giving us the decision rule to set quantity such that
price equals marginal cost. And then, once again, it generates the following result
that we see in our graph here. If you'd like to play around with it,
you can move q1 around. And you'll find that what
maximizes the size of the profits created in this case is placing q1 where
we've placed it on the graph here.