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Wize AP Microeconomics Textbook > Firms in Competitive Markets (Perfect Competition)

Profit Maximization

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Profit Maximization

Perfect competition is an industry with many firms and 5 key assumptions:

  1. Every firm is a price taker. This means they have to charge the same price and don't have the market power to charge a different price. Example: Gas stations & vegetable stores selling lettuce or broccoli.
  2. All firms are selling the same product. This is why they have to charge the same price, because they are selling the same quality product.
  3. Free entry/exit in to the industry (no barriers to entry/exit). Any business can enter or leave whenever they want, that's why there is so much competition.
  4. There are many buyers and sellers.
  5. Buyers have full information.

Marginal Revenue

  • This is the additional revenue the firm earns from selling one extra unit of the product. The marginal revenue is the price (only in perfect competition!) because every firm is a price taker (charging the same price) so the additional revenue from each extra unit is just the price.
  • The average revenue means on average how much is the firm making in revenue on each unit they sell. This is also the same thing as the price (in every industry).

Wize Tip
The marginal revenue is the price in perfect competition only!

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Profit Maximization

Profits are maximized when:
 Price (Marginal Revenue) = MC (Marginal Cost)\boxed{\text{\ Price\ (Marginal\ Revenue)\ =\ MC\ (Marginal\ Cost)}}

  • If Price > Marginal Cost (MC) the firm should
    increase
    output
  • If Price < Marginal Cost (MC) the firm should
    decrease
    output
  • In the graph above, the profit is maximized at an output of
    10
    units.
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Steps to find the Profit

  1. Find the quantity where P = MC
  2. See where that quantity (output of 10 from the diagram above) hits the ATC
  3. Find profit by using the following equation:

Profit=(Price−ATC)⋅Q\boxed{\text{Profit}=\left(Price-ATC\right)\cdot Q}

Profit = (20 - 15) * 10 = $50


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Example: Profit Maximization

If the price faced by a perfectly competitive firm is equal to $60, then the maximum profit this firm will earn is:
A) $(60 - D)x2
B) $(60 - C)x3
C) $(60 - B)x4
D) $(60 - B)x5
E) $(60 - A)x5


E.
Step 1. Find where Price = MC which is an output of 5.
Step 2. Plug that output in ATC which is at A
Step 3. Profit = (P - ATC) * Q = (60 - A) * 5

Practice: Profit Maximization

If the market price in a perfectly competitive industry is $14 and a new firm enters this market with a marginal cost equation of MC = 2Q + 4 and an average total cost equation of ATC = Q + 4 + Q/5 what would be the new firm's output and profit?