8.2 How Perfectly Competitive Firms Make Output Decisions

Profit maximization in perfect competition is all about finding the sweet spot. Firms need to produce where price equals marginal cost to maximize profits. This rule helps them figure out how much to make in a market where they can't control prices.

Once firms know how much to produce, they can see if they're making money. By comparing price to average total cost, they can tell if they're profitable or losing cash. If things get tough, they might need to decide whether to keep going or shut down temporarily.

Profit Maximization in Perfect Competition

Profit-Maximizing Quantity

• Perfectly competitive firms are price takers face a perfectly elastic demand curve must accept the market equilibrium price ($P$)
• To maximize profits, the firm produces where marginal revenue ($MR$) equals marginal cost ($MC$) for a price taking firm, $MR = P$ therefore, the profit-maximizing rule is to produce where $P = MC$
• At the quantity where $P = MC$, the firm is making the most possible profit (minimizing losses) producing less than this quantity means missing out on profitable sales producing more than this quantity means incurring marginal costs greater than marginal revenue

Evaluating Profits and Losses

Profitability

• Once a firm determines its profit-maximizing quantity, it can evaluate profitability by comparing $P$ to average total cost ($ATC$) at that quantity
• If $P > ATC$, the firm is earning economic profits revenue per unit exceeds total cost per unit (positive profit margin)
• If $P < ATC$, the firm is incurring economic losses revenue per unit is less than total cost per unit (negative profit margin)
• If $P = ATC$, the firm is earning zero economic profits (normal profits) revenue per unit equals total cost per unit the firm is breaking even (zero profit margin)

Short-Run Shutdown Decision

• If a firm is losing money in the short run, it must decide whether to temporarily shut down or remain in operation
• The shutdown rule states that a firm should continue operating in the short run if $P \geq AVC$ if $P < AVC$, the firm should temporarily shut down $AVC$ represents the variable costs per unit that can be avoided by shutting down (electricity, materials)
• If $P > AVC$, the firm should keep producing even if it's incurring losses by producing, the firm can offset some of its fixed costs (rent, equipment leases) the loss from producing is less than the loss from shutting down and incurring all fixed costs
• If $P < AVC$, the firm minimizes losses by temporarily shutting down the revenue generated by producing is not enough to cover the variable costs it is better to shut down, incur the fixed costs, and avoid the variable costs of production