Why is price equal to marginal cost in perfect competition

The condition P=MC refers to the price corresponding to the maximum quantity of a commodity produced/supplied by a producer-supplier that is earning profits of net-zero or more and is not price-setting.

Your question is "if the price of commodity X equals the marginal cost of producing X then why produce more X?" The answer is that it is not rational to produce more X.

The condition P=MC refers to the greatest price a profit-maximzing producer can set for what it produces if that producer faces a perfectly competitive market, because producers/suppliers cannot price-set in a perfectly competitive market but will not produce for profits less than net-zero.

Assuming no price-setting: ceteris paribus, if firms A and B have the same marginal cost and enjoy the same profit but A faces a perfectly competitive market and B is a monopoly then B produces less than A, which increases the price of the commodity it produces.

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Pure or perfect competition is rare in the real world, but the model is important because it helps analyze industries with characteristics similar to pure competition. This model provides a context in which to apply revenue and cost concepts developed in the previous lecture. Examples of this model are stock market and agricultural industries.

1. Many sellers: there are enough so that a single seller’s decision has no impact on market price.

2. Homogenous or standardized products: each seller’s product is identical to its competitors’.

3. Firms are price takers: individual firms must accept the market price and can exert no influence on price.

4. Free entry and exit: no significant barriers prevent firms from entering or leaving the industry.

The individual firm will view its demand as perfectly elastic. A perfectly elastic demand curve is a horizontal line at the price. The demand curve for the industry is not perfectly elastic, it only appears that way to the individual firms, since they must take the market price no matter what quantity they produce. Therefore, the firm’s demand curve is a horizontal line at the market price.

Marginal revenue (MR) is the increase in total revenue resulting from a one-unit increase in output. Since the price is constant in the perfect competition. The increase in total revenue from producing 1 extra unit will equal to the price. Therefore, P= MR in perfect competition.

Short Run Analysis

In the short run, the firm has fixed resources and maximizes profit or minimizes loss by adjusting output. Firms should produce if the difference between total revenue and total cost is profitable (EP >0), or if the loss is less than the fixed cost (EP> - FC). The firm should not produce, but should shut down in the short run if its loss exceeds its fixed costs. By shutting down, its loss will just equal those fixed costs. Fixed cost in real life would be rent of the office, business license fees, equipment lease, etc. These cost would have to be paid with or without any output. Therefore, fixed cost would be the loss of shut down at any time. If by producing one unit of output, this loss could be lowered, then this unit should be produced to minimize the loss. However, if by producing one unit of output, this loss would be higher , then this unit should not be produced. The firm should shut down, just pay for the fixed cost.

If EP< - FC  firm should shut down. Then its lost will be the Fixed cost. EP = - FC. In order for EP < - FC, market price, P, must be lower than the minimum AVC.

If EP>- FC, firm should produce. That is when market price is greater than minimum AVC.

Marginal revenue and marginal cost (MC) are compared to decide the profit-maximizing output.

If MR > MC, then the firm should continue to produce.

If MR = MC, then the firm should stop producing the additional unit. As the additional unit’s MC would be higher according to law of diminishing returns, MR would be less than MC; that is, the firm would loss profit by producing additional units. Therefore, this is the profit maximizing output level.

If MR < MC, then the firm should lower its output.

In conclusion:

The shutdown point is the level of output and price at which the firm just covers its total variable cost. If the MR of the product is less than the minimum average variable cost (min AVC), the firm will shut down because this action minimizes the firm’s loss. In this case, the firm’s economic loss equals its total fixed costs. If MR < min AVC, then each additional unit produced would increase the loss. For pure competition, MR is equal to price as the firm is facing a perfectly elastic demand. Therefore, for short run, if Price < min AVC, then the firm should shut down. If Price > min AVC, then the firm should produce. Price and MC are compared to find the profit maximizing or loss minimizing output level. The supply curve of the pure competition firms would be the portion of the MC curve above the min AVC.

1. If EP < - FC or Market P < Min AVC, firm should shut down. Output = 0 , and EP = -FC

2. If EP > - FC or Market P > Min AVC, firm should produce. Firm's output level should be at where MR=MC or P=MC.  Use EP = TR - TC to get economic profit of the firm.

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Four Market Structures

The focus of this lecture is the four market structures. Students will learn the characteristics of pure competition, pure monopoly, monopolistic competition, and oligopoly. Using the cost schedule from the previous lecture, the idea of profit maximization is explored.

OBJECTIVES

1. Identify various market structures and their characteristics.

2. Be able to category firms into four market structures.

3. Describe the effects of imperfect competition upon the market and the firm.

4. Understand the pricing structure of the four structures.

TOPICS

Please read all the lectures by clicking on the following topics.

PERFECT COMPETITION

PERFECT COMPETITION CONT.

PERFECT COMPETITION EXAMPLE

PURE MONOPOLY

MONOPOLY EXAMPLE

PRICE DISCRIMINATION

MONOPOLISTIC COMPETITION

OLIGOPOLY

TECHNOLOGICAL DEVELOPMENT

ECONOMIC EFFICIENCY

Lecture One    Lecture Two    Lecture Three   Lecture Four   Lecture Five   Lecture Six  Home

Marginal revenue (MR) and marginal cost (MC) affect how a company makes its production decisions. Marginal cost (MC) refers to the increase in cost that is occasioned by the production of an extra unit. It is the additional cost of producing an additional unit.

Marginal revenue (MR) refers to the extra profit made by producing or selling an extra unit.

Perfect Competition

We’ll start with the perfect competition here because it is the easiest to understand. In perfect competition, each firm produces at a point where price (P) equals marginal revenue (MR) and average revenue (AR). As seen before, each firm does not make any economic profit in the long run. The quantity produced by each firm is also the point where the average cost (AC) equals marginal cost  (MC).

In a competitive market, individual buyers and sellers represent a very small share of total transactions made in the market. Therefore, they do not influence the prices of their products. Any individual firm is a price taker, and it is the market forces of demand and supply that determine the price.

In perfect competition, total revenue (TR) is equal to price times quantity for any given demand function. Mathematically it is represented as TR = P×Q. 

Each firm in a perfect competition does not make any economic profit in the long run; however, profit-maximizing firms will maximize profits when they produce Q quantities when MC=MR. The quantity produced by each firm is also the point where the average total cost (ATC) equals marginal cost (MC). Economic profit is maximized at the point at which marginal revenue (MR)=marginal cost(MC) in the short run, as indicated in the graph below.

It’s important to note that the profit maximization process occurs when total revenue (TR) exceeds total costs (TC) by a maximum amount, as shown below.

In a perfectly competitive market, individual buyers and sellers represent a very small share of total transactions made in the market. Therefore, they do not influence the prices of their products. Any individual firm is a price taker, and it is the market forces of demand and supply that determine the price resulting in a perfectly elastic demand as shown below;

The relationship between change in prices and change in quantities demanded is referred to as price elasticity. Total revenue is maximized when marginal revenue is zero; hence total revenue will only decrease when marginal revenue becomes zero. Therefore, the elasticity of demand in this regard shows that the percentage decrease in price is greater than the percentage increase in quantity demanded.

Monopolistic Competition

Goods produced under monopolistic competition are differentiated from one another by branding. It means that these firms have some control over their prices. However, raising these prices may cause some customers to shift to other products considered close substitutes. As a result, demand for these products will fall.

If a firm lowers the prices of its products, buyers will shift from buying other products and start buying its products. Consequently, the demand for the products will rise.

Generally, a firm under monopolistic competition can best be described by its elasticity (responsiveness) to demand. When demand is high, it increases the price of goods to maximize profit. It creates some supernormal profit, as seen in the graph below.

A firm will likely maximize its profits if its marginal cost (MC) equals its marginal revenue (MR), as shown in the graph, and it will earn an economic profit when the price P1 is above the average cost C1.

On the other hand, when demand is low, the firm will lower its prices to win more customers. In the long run, other firms can also enter the market and compete to eliminate the supernormal profits. As a result, the profits of the monopolistic competitive firm will be normalized.

Oligopoly

Firms under this market structure are assumed to generally work towards the protection and maintenance of their share of the market. In other words, all firms may match one another’s prices. If one of the businesses raises its price, then a large substitution effect takes place. As a result, demand becomes relatively elastic.

From the above graph, the kink price is at P1 when the firm produces Q1. The firm anticipates that if the prices go above P1, the market competitors will maintain the prices at P1, resulting in a loss of market share.

Above P1, the demand curve is relatively elastic, i.e., an increase in price leads to a huge decrease in demand, while below P1, competitors will match the reduced prices, and therefore, the firm will maximize its profits at Q1.

The marginal revenue associated with each demand structure also differs in the oligopoly, and each is synonymous with a different part of the kinked demand curve.

The level of output that maximizes profit occurs where marginal revenue (MR) is equal to marginal cost (MC), that is, MR=MC as indicated in the graph above.

Monopoly

Since only one firm controls the whole market for a monopoly, the demand curve will be the average revenue curve (AR=D). The quantity that the monopolist will produce is when marginal revenue equals marginal cost (MR=MC), just like in perfect competition, the profit-maximizing output.

However, since the marginal and average revenue curves are separate, the monopolist will charge the price PM at the top as illustrated in the graph below;

Since the monopolist produces QC but charges the price PC, this creates a “box” of supernormal profit from PM to PC and QM to QC.

In this form of market, the demand is relatively inelastic. It means that consumers buy about the same amount whether the price drops or rises. The monopolist needs to lower their prices by offering bundles or discounts to produce more.

Over time, the market share of a dominant oligopoly firm:

1. increases.
2. decreases.
3. remains constant.

Solution

The correct answer is B.

Over time, the profits made by the dominant oligopoly firm will attract more investors or companies to the industry. Therefore, the market share of the dominant firm will decrease.