In a perfectly competitive market, firms aim to maximize profit by determining the optimal level of output. Here’s how the profit-maximizing output decision works in the long run when all inputs and costs are variable:
Characteristics of Perfect Competition
- Many Sellers: Numerous firms compete in the market, each selling identical products.
- Price Taker: Firms have no control over the market price; they accept the prevailing market price determined by supply and demand.
- Free Entry and Exit: Firms can enter or exit the market freely, ensuring that long-term profits are driven to zero.
Profit Maximization in the Long Run
- Short-Run Decision: In the short run, firms will maximize profits by producing at the output level where marginal cost (MC) equals marginal revenue (MR). Since firms are price takers, MR is equal to the market price (P). Therefore, the condition for profit maximization is: MC=MR=PMC = MR = PMC=MR=P
- Long-Run Adjustments:
- If firms in the industry are making economic profits (total revenue exceeds total costs), new firms will be incentivized to enter the market due to the absence of entry barriers.
- This influx of new firms will increase market supply, leading to a decrease in the market price.
- Return to Normal Profits: As the market price falls due to increased competition, existing firms will adjust their output. Eventually, the price will fall to the level of the minimum average total cost (ATC) of production, where firms make zero economic profit (normal profit). The long-run equilibrium occurs at this point:P=MC=ATCP = MC = ATCP=MC=ATC
- Long-Run Equilibrium:
- In the long-run equilibrium, firms produce at the lowest point of their average total cost curve, ensuring efficiency.
- No economic profits exist, as any potential profits are eroded by new entrants, while losses lead to firms exiting the market.
Implications
- Efficiency: The long-run outcome ensures that resources are allocated efficiently, as firms produce at the minimum ATC, reflecting both productive and allocative efficiency.
- No Incentive for Further Entry or Exit: At this equilibrium point, there is no incentive for firms to enter or exit the market, stabilizing the industry in the long run.
In summary, perfectly competitive firms maximize profit by producing where marginal cost equals marginal revenue, and in the long run, due to free entry and exit, they operate where price equals minimum average total cost, resulting in zero economic profit.