How perfectly competitive firms make output decisions

Posted 2023-02-21 15:16:17

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:

Profit = T o t a l r e v e n u e - T o t a l c o s t

Profit = (Price) (Q u a n t i t y p r o d u c e d) - (A v e r a g e c o s t) (Q u a n t i t y p r o d u c e d)

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.

Total cost and total revenue at the raspberry farm
Quantity, start text, Q, end text	Total cost, start text, T, C, end text	Fixed cost, start text, F, C, end text	Variable cost, start text, V, C, end text	Total revenue, start text, T, R, end text	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.

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