Since the purely competitive firm is a price-taker, then to increase its revenue in short run it can change only quantity output. Thus it can adjust its output by changes in amount of variable resources (materials, labor) it uses. So to maximize its revenues or to minimize its losses our firm has to adjust its quantity of resources used.
There are two ways how to calculate the level of output for which our firm, in a pure competitive market, will get highest revenues. One of the methods is to compare total revenues and total costs, and another one is to compare marginal revenues and marginal costs. By the way, these methods can be applied not just in pure competitive market but also in pure monopoly, monopolistic competitive market and oligopoly.
Total Revenue- Total Cost Approach
Total cost increases with output, because more production require more resources, but the rate of increase in the total cost varies with the efficiency of the firm. Specifically, the cost data reflect law of diminishing returns. Initially it increases with smaller amounts but after a point total cost rise by increasing amounts. Total revenue covers all costs (including normal profit) but there isn’t an economic profit. Economists call break-even point: an output value for which a firm makes a normal profit but not an economic profit. Any output between two break-even points produces an economic profit. The firm achieves maximum profit, where the vertical distance between Total Revenue and Total Cost is greatest.
Marginal Revenue- Marginal Cost Approach
In this approach the firm compares marginal revenue (MR) and (MC) of each successive unit of output. The firm will produce any output for which marginal revenue is greater than marginal benefit because the firm will add more revenue from selling that item than the costs of producing it.
In the initial stages of production, when output is relatively low then the Marginal Revenue (MR) is usually greater than Marginal Cost (MC). So it’s profitable to produce in this range of output. But with additional units of output where quantity produced is relatively high, rising marginal cost will become greater than the marginal revenue. That’s why firms will try to avoid output quantity in this range. A point, where marginal revenue equals with marginal cost, separates these two regions. In the short run, the firm will maximize profits or minimize its loss by producing that quantity of output where marginal cost equals with marginal benefit. This profit maximizing rule is known as MR=MC Rule.
Characteristics of MR=MC rule
There are some important features of MR=MC rule and they can be stated as follows:
- The rule is applied only if producing is preferable to shutting down.
- The rule of profit maximization is applied to all firms whether they are purely competitive, monopolistic, monopolistically competitive, or oligopolistic.
- In pure competitive market our rule is transformed into P=MC, because demand faced by this seller is perfectly elastic. In this case marginal cost is equal to marginal revenue. So only in pure competitive market we may substitute P (price) instead of MR.
Profit Maximization Rule
How to determine the profit maximization output? It’s quite easy, all output values for which marginal revenue is greater than marginal cost add to total revenue, so the maximizing output is the last value for which marginal revenue is bigger than marginal cost. In Short Run the firm produces its goods until total revenue is greater than negative Average fixed Cost, however, if it is smaller, then it is better to shut down. Take care, “shut down” doesn’t mean to get off from market, because in short run a firm can’t leave the market.
An example of Total Revenue and Total Cost -Quantity Demanded Graph(maximum economic profit is taken randomly, since no values are present) :