We have assumed that no individual seller has control over market price as each seller produces a very small fraction of the total quantity supplied in the market. As a result, if the sellers want to sell their products, they will find no option but to accept the prevailing market price (P in figure 10.1).
As we have already mentioned that price is fixed irrespective of individual seller’s output level, the line representing product price is a straight line parallel to the horizontal axis [panel (b) of figure 10.1]. This line indicates that even if output level of any individual firm changes, i.e., if Q varies, price remains fixed at P.
Since the price is fixed, MR and P are equal, because, additional revenue derived by selling one additional unit of the good is the unit price (P) of that good. In a perfectly competitive set up, AR and P of any firm are also equal, since
The relation among P, AR, and MR is shown in the following table where it is assumed that price is fixed at Rs. 10 per unit.
Price (in Rs.)
(TR ” TRJ
From our previous discussion on cost structure, it is clear that both marginal and average cost curves are U-shaped. We are also aware that MC curve always passes through the minimum point of the AC curve (fig. 10.2).
B. Profit Maximising Output Level:
Profit maximizing firm has two clear options: produce or not to produce. If the firm decides not to produce anything, it will incur a loss equal to the fixed cost that has already been invested. If the firm chooses to produce, it will incur variable cost in addition to the fixed cost.
Variable cost can be recovered if the firm can sell the product at a price above its average variable cost. So it is profitable for a firm to go for production only if revenue exceeds variable cost.
Once the firm decides to produce, it needs to know how much to produce in order to maximize profit. Now, we search for the quantity that maximizes profit for an individual firm. So long as MR (marginal revenue) exceeds MC (marginal cost), per unit price (or revenue) remains higher than per unit cost of production, and hence expansion of output creates more profits.
For example, at output level ‘Ob’, the firm gets ‘ab’ amount by selling one unit output while the cost of production of one unit of output is only ‘mb’ (figure 10.3). Obviously, the firm will increase production and produce more than ‘Ob’ units, because for the firm at this output level more output leads to increase in total profit.
When the firm increases its output to ‘Of, cost of producing one unit of output is ‘ef whereas ‘nf’ amount will be received by selling one unit of output. Hence, each unit of output causes loss for the firm. This is not only true for ‘Of’ quantity of outputs but also for all output levels for which MC exceeds MR.
In figure 10.3, we observe that for all output levels exceeding OQ, MC is higher than MR. So, a firm should not produce more than OQ units, since for any further expansion of output beyond OQ, MC exceeds MR, and total profit of the firm reduces.
At output level OQ, marginal cost and marginal revenue are equal (i.e., MC=MR). Output level OQ maximizes total profit of the firm, since as we have seen; any output below or above OQ reduces total profit of the firm.
Thus, from the above analysis it is clear that, any profit maximising firm will produce till the marginal cost (or the cost incurred to produce the last unit of output) equals MR (the amount received by selling the last unit of output). Equality of MC and MR is known as necessary condition or first order condition.
But equality of MC and MR does not ensure that profit maximising point is reached. Because, both MC and MR are equal at point ‘a’ and also at point ‘r’ (see figure 10.4). Since total profit is not maximised at point ‘r’, it is required to differentiate point ‘a’ from ‘r’.
In order to do that, we need to introduce another condition so that fulfillment of both the conditions automatically indicates no other point than point ‘a’. This second condition is expressed as:
Slope of MR < slope of MC, at the point where MC = MR.
In the literature of economics, this condition is known as sufficient condition or second order condition.
Consider figure 10.4. Per unit price is given as OP and we have determined OQ as profit maximizing output. Hence, for a profit maximizing firm,
TR = (OP) ? (OQ)
= area OP aQ
From figure 10.4 we find that average cost corresponding to OQ output level is ‘bQ’. So, total cost of production
TC = (OQ) ? (bQ)
= area OcbQ
Therefore, Total profit = TR – TC
= (area OP aQ) – (area OcbQ) = area Pabc
It should be mentioned here that average cost includes ‘normal profit’ or normal rate of market return on capital employed. At price level OP the firm receives ‘above normal profit’ per unit of output which is equal to PC. Total above normal profit is represented by the rectangle P abc. Above normal profit is also known as ‘super normal profit’.