Question

Clarify profit maximization of a competitive firm with the help of diagram.

Hint:

For a competitive firm, the point where marginal cost equals marginal revenue determines the level of output that maximizes profit.

Answer 1

In a perfectly competitive market, profit maximization occurs when a firm produces the quantity of output where marginal cost (MC) equals marginal revenue (MR). Below is an explanation of the profit maximization process and a diagram illustrating it.

Step 1: Profit Maximization Condition.
For a competitive firm, profit is maximized when marginal cost equals marginal revenue: \[ MC = MR \] At this point, the firm cannot increase its profit by producing more or less output. The firm’s price is determined by the market, and it is equal to both the marginal revenue and the average revenue.

Step 2: Diagram Explanation.
The diagram below illustrates the concept of profit maximization in a competitive firm: - The marginal cost (MC) curve is U-shaped and shows the additional cost of producing one more unit of output.
- The marginal revenue (MR) curve is horizontal in a perfectly competitive market because the firm is a price taker, and the price is constant at all levels of output.
- The firm maximizes its profit by producing the quantity of output where MC = MR, represented by the intersection point of the MC and MR curves.
If the price is above average cost (AC) at the profit-maximizing level of output, the firm earns a profit. If the price is below AC, the firm incurs a loss.