Perfect Competition Profit Maximization is attainable through the production level at which marginal revenue (MR) equals marginal cost (MC). MC is the change in total revenue resulting from sales proceeds. In a perfect competition market, the marginal revenue equates to the market price of a product or service.
When Perfect Competition Profit Maximization Occur
Profit maximization is possible where MR = MC because the market prices are equal to or greater than the average variable cost (AVC).
To understand why the profit-maximizing output is where MR equals MC, let’s revisit the relationship between MR, MC, and Total Revenue (TR). An increase in a firm’s output volume potentially increases total revenue. However, this increase in total income depends on the marginal revenue of the extra production units.
When this marginal revenue of the additional units exceeds the marginal cost, producing the additional units increases the profitability of a business in a perfect competition market. On the other hand, if the marginal revenue is less than the marginal cost, producing the additional output unit causes lower profitability to the firm/business in question.
If the market price of goods or services a company sells are equal to the average variable cost but less than the average total cost, such a company will likely be profitable in the short run. However, profitability might be uncertain in the long run if market conditions remain unchanged.
Where the market price is greater than or equal to the average total cost, such a company’s profitability is more future-proof. Even though there are no substantial profits in the short run, the long run might hold too much profit potential.
Perfect Competition Profit Maximization in Short-Run
A company in a perfect competition market can profit or lose. If you own a business in this kind of market structure, you can gauge the probability of your profitability using the following formula:
Profit = Total Revenue – Total Cost
If your business’s total revenue is greater than the total cost incurred, your firm will earn a profit. If the total cost you incur exceeds your business’s total revenue, you are at a loss. If the total revenue you earn equals the total cost you incur, this is a breakeven point for your business.
In the short run, your business will profit if the market price of the goods or services you sell exceeds the average variable cost.
If the market price of the goods or services you sell exceeds the average variable cost but is less than the average total cost, your business can bring in profits in the long run. If the market price exceeds your average total cost, your business will earn profits, provided the market conditions remain constant.
Perfect Competition Profit Maximization in Long-Run
In the long run, your business in perfect competition can earn only a normal profit, as supernormal profits are only possible in the short run, courtesy of market volatility. However, much will happen in the market this long as your business excels. New payers will have entered the market, while others will have exited.
If firms operating in the same perfect market structure as yours are making profits, new players will enter the market. They will increase the supply of whatever products or services. At some point, players will be so many for a slowly growing market demand hence a potential decrease in market prices.
The opposite is true; some will exit if your industry is shrinking and players are making consistent losses. This will decrease the supply of the goods or services in question. Such a decrease in supply will trigger an upward movement along the demand curve, hence a potential price rise. Ultimately, the market price will equate to the average total cost (ATC) incurred by exiting players.
In the long run, profitability is more attainable when a company takes advantage of economies of scale. As your company/business increases its output, you can spread its fixed costs over a wider output array, hence a lower average cost per unit.
In the long run, your company, in the perfect competition market structure, will produce at the lowest point of the ATC curve. Your business will be most efficient at this point hence the possibility of profit maximization.
If your business ends up at a lower production output level, you will incur higher average costs, resulting in reduced profits.
Note: If you pursue a scenario where your company’s production is in the highest possible output, diseconomies of scale may take their course. Your business will spend more on higher average costs, resulting in lower profits.
Entry and Exit in Perfect Competition
Entry and exit from the perfect competition market are easy for most players. More entrants in the market force the supply curve to shift to the right. Consequently, existing players lower their prices. As the market price takes a further downward trajectory, existing firms’ profitability decreases. At the point where profits are so minimal, some players result in an exit.
As more players exit, the supply curve takes a U-turn and shifts to the left. It creates more stability as supply and demand approach equilibrium. Prices stabilize as market prices of goods and services increase. This process continues until the market price is equal to the minimum point of the ATC curve.