 Pricing & Output decisions under

Perfect Competition

1
Perfectly Competitive Market
A perfectly Competitive market is
characterized by:
1. There are many firms.
2. The product is standardized, or
homogeneous.
3. Firms can freely enter or leave the
market in the long run.
4. Each firm takes the market price as
given.
2
The Short-run Output Decision
The firm’s objective is to produce the
level of output that will maximize
profit.
Economic profit = total revenue (TR)
minus total economic cost (TC).
Total revenue = price × quantity sold.
The cost structure of the business firm
is the same as the one we studied
earlier.
3
 The Firm’s TC Structure (Revisited)

The shape of the total cost curve Output: Total

Rakes per Fixed Variable Short-run
comes from diminishing returns Minute Cost Cost Total Cost

in the short run. Q

0
FC
36
TVC
0
STC
36
1 36 8 44

ST C  T F C  ST V C 2
3
36
36
12
15
48
51
4 36 20 56
Short-run 5 36 27 63
Short-run Total
Total Cost = Fixed Cost + Total 6 36 36 72
Variable Cost 7 36 48 84
8 36 65 101
9 36 90 126
10 36 130 166

4
The Revenue Structure of the
Competitive Business Firm
The perfectly competitive firm is
a price-taking firm. This means
that the firm takes the price
from the market.
As long as the market remains
in equilibrium, the firm faces
only one price—the equilibrium
market price.
5
Computing the Total Revenue of a
Price-taker

Total Revenue
Output: Total 250

Rakes per Revenue

C o s t in $
200
Minute Price ($) ($)
150
Q P TR
0 25 0.00 100

1 25 25.00 50
2 25 50.00
0
3 25 75.00 0 1 2 3 4 5 6 7 8 9 10
4 25 100.00 Output: Rakes per minute
5 25 125.00
6 25 150.00  Since the perfectly competitive firm
7 25 175.00 faces a constant price, the shape of its
8 25 200.00
9 25 225.00
total revenue is an upward-sloping
10 25 250.00 line. Total revenue changes only with
changes in the quantity sold.
6
The Totals Approach to Profit Maximization

To maximize profit, a

producer finds the
largest gap between total Output:
Rakes per
Total
Revenue Short-run
revenue and total cost. Minute ($) Total Cost Profit

Q TR STC
0 0.00 36 -36
1 25.00 44 -19
2 50.00 48 2
3 75.00 51 24
4 100.00 56 44
5 125.00 63 62
6 150.00 72 78
7 175.00 84 91
8 200.00 101 99
9 225.00 126 99
10 250.00 166 84

7
The Marginal Approach

The other way to decide how much

output to produce involves the
marginal principle.
Marginal PRINCIPLE
Increase the level of an activity if its marginal
benefit exceeds its marginal cost, but reduce the
level if the marginal cost exceeds the marginal
benefit. If possible, pick the level at which the
marginal benefit equals the marginal cost.

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Marginal Revenue

The benefit of producing and

selling rakes is the revenue the
firm collects. If the firm sells
one more rake, total revenue
increases by $25.
Marginal benefit = marginal
revenue = market price
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The Marginal Rule for Profit Maximization

A firm maximizes
profit in accordance Output:
Rakes per
Marginal
Revenue =
Short-run
Marginal

with the marginal Minute

Q
Price ($)
P
Cost
SMC
Profit

principle—by 0
1
25
25
-
8
-36
-19

setting marginal
2 25 4 2
3 25 3 24
4 25 5 44

revenue (or market 5

6
25
25
7
9
62
78

price) equal to
7 25 12 91
8 25 17 99
9 25 25 99

marginal cost. 10 25 40 84

10
Zero Profit or Loss Where
MC=MR
 Firms can also earn zero profit or even a
loss where MC = MR.
 Even though economic profit is zero, all
resources, including entrepreneurs, are
being paid their opportunity costs.

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Zero Profit or Loss Where
MC=MR
 In all three cases (profit, loss, zero
profit), determining the profit-
maximizing output level does not depend
on fixed cost or average total cost, by
only where marginal cost equals price.

12
The Shutdown Point
 The firm will shut down if it cannot
cover average variable costs.
 A firm should continue to produce as long
as price is greater than average variable
cost.
 Once price falls below that point it makes
sense to shut down temporarily and save
the variable costs.

13
The Shutdown Point
 The shutdown point is the point at which
the firm will gain more by shutting down
than it will by staying in business.

14
The Shutdown Point
 As long as total revenue is more than
total variable cost, temporarily
producing at a loss is the firm’s best
strategy since it is taking less of a loss
than it would by shutting down.

15
 Thanks

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