Profit maximisation and supply
Every firm, whatever its market, faces the same question: how much should it produce? The answer comes from comparing marginal revenue and marginal cost.
Marginal revenue
Marginal revenue (MR) is the extra revenue from selling one more unit. For a firm in a competitive market, which can sell as much as it likes at the market price, MR equals the price. For firms that must lower price to sell more, MR is less than price.
The profit-maximising rule
A firm maximises profit by producing where marginal revenue equals marginal cost (MR = MC). If MR exceeds MC, producing one more unit adds more revenue than cost, so expand. If MC exceeds MR, the last unit lost money, so cut back. This rule applies to every market structure.
Worked example
A competitive firm sells at 50 dollars each. Its marginal costs for successive units are 20, 30, 40, 50, 60. It produces units 1 to 4, since each adds at least as much revenue as cost. The fifth unit costs 60 but brings only 50, so it stops at 4 units.
Calculating profit
Profit equals (price - average total cost) x quantity. If price is 50 and ATC at 4 units is 35, profit is (50 - 35) x 4 = 60 dollars. On a graph, profit is the rectangle between price and ATC at the chosen quantity.
The shutdown decision
In the short run, a firm making losses should keep producing if price covers average variable cost, because revenue then pays all variable costs and some fixed costs, which it must pay anyway. If price falls below the minimum of AVC, it should shut down temporarily, losing only its fixed costs.
The firm's supply curve
For a competitive firm, the short-run supply curve is its marginal cost curve above the minimum of AVC: at each price, it produces where price equals MC. Adding up all firms' supply curves gives the market supply curve, linking upward-sloping supply to rising marginal costs.
Exit and entry in the long run
In the long run, firms exit an industry if price stays below average total cost, because they can cover all costs elsewhere. Firms enter when economic profits are positive. Entry and exit push prices toward the minimum of average total cost.
Common mistakes
Maximising revenue or output instead of profit. Using average instead of marginal values to decide on one more unit. Shutting down whenever there is a loss, ignoring that fixed costs must be paid anyway in the short run. Letting sunk costs drive decisions.
Key takeaways
Marginal revenue is the extra revenue from one more unit; for competitive firms it equals price. Profit is maximised where MR = MC. Profit = (P - ATC) x Q. In the short run, keep producing if price covers AVC; otherwise shut down. The competitive firm's supply curve is its MC curve above AVC. Long-run entry and exit push price toward minimum ATC.
Flashcard
Extra revenue from one more unit
Check your understanding
In the short run, a firm's price is 8, its average variable cost is 6, and its average total cost is 10. What should it do?