Profit Maximization and Competitive Supply Explained

Posted on Apr 4, 2025 in Economics

Profit

  1. Profit is total revenue minus total cost. Total cost includes explicit and implicit costs. Economic profit occurs when total revenue is greater than total cost. Normal profit occurs when total revenue is equal to total cost. Economic loss occurs when total revenue is less than total cost.
  2. The firm’s goal is to maximize profit. The firm will choose the profit-maximizing level of output where marginal revenue equals marginal cost.
  3. If the firm is not at the output where marginal revenue equals marginal cost, then the firm can increase profit by changing the level of output. If marginal revenue is greater than marginal cost, then by increasing output, profit goes up. If marginal revenue is less than marginal cost, then by reducing output, profit goes up.
  4. Like the perfectly competitive firm, the monopoly firm maximizes profit by choosing the level of output where marginal revenue equals marginal cost. However, for the monopolist, the price is determined by demand at the profit-maximizing level of output.
  5. In the short run, a perfectly competitive firm cannot leave the industry because some factor is fixed. The firm may make an economic profit, economic loss, or a normal profit.

Perfectly Competitive Supply

  1. If the perfectly competitive firm makes an economic loss in the short run, it may shut down. If price is less than average variable cost, the firm will shut down. If price is greater than average variable cost, the firm will continue producing.
  2. Supply for the perfectly competitive firm is marginal cost above average variable cost.
  3. In the long run, all factors are variable. If firms make an economic profit, then new firms will be attracted into the perfectly competitive industry, which will increase the market supply and lower the market price. The lower market price will reduce marginal revenue and hence profit for the firm.
  4. If firms make an economic loss, firms will leave the industry in the long run. The reduction in supply will raise price and revenue. Thus, in the long-run equilibrium, the perfectly competitive firm earns a normal profit.
  5. An efficient allocation of resources occurs when a good is produced at its lowest possible opportunity cost, where the average total cost is lowest. The perfectly competitive firm always produces efficiently in the long run.

Perfectly Competitive Supply

  1. If the perfectly competitive firm makes an economic loss in the short run, it may shut down. If price is less than average variable cost, the firm will shut down. If price is greater than average variable cost, the firm will continue producing.
  2. Supply for the perfectly competitive firm is marginal cost above average variable cost.
  3. In the long run, all factors are variable. If firms make an economic profit, then new firms will be attracted into the perfectly competitive industry, which will increase the market supply and lower the market price. The lower market price will reduce marginal revenue and hence profit for the firm.
  4. If firms make an economic loss, firms will leave the industry in the long run. The reduction in supply will raise price and revenue. Thus, in the long-run equilibrium, the perfectly competitive firm earns a normal profit.
  5. An efficient allocation of resources occurs when a good is produced at its lowest possible opportunity cost, where the average total cost is lowest. The perfectly competitive firm always produces efficiently in the long run.