Question

a. List and explain the three characteristics of the MR-MC approach to determining the profit maximizing output and price for the purely competitive firm.
i. Please refer to the slide that discusses short run profit maximization Key Rule regarding the MC – MR approach and the audio to prepare the answer.
b. From the point of view of the business manager, thoroughly explain how the purely competitive firm in the short run would determine its optimal level of output and price using the MR-MC approach, for the:
   i.   Profit maximizing case
   ii.   Loss minimizing case
   iii.   Shut down case

Answer 1

a)

MR-MC approach is used to determine profit maximizing output and price.

• MR should be equal to MC.
• MC must cut MR from below.
• Same condition is used across the markets.
• In perfectly competitive market where Price is constant hence P =MR, thus new condition is used for equilibrium; P =MC.

b)

(i)

Profit is maximized where MR and MC are equal or P= MC.

ii)

Loss is minimized where firm attempts to recover part of fixed cost by increasing revenue. Price decided through MR -MC must be above the AVC of firm. Hence, here firm will be able to recover part of fixed cost.

iii)

Comparison between AVC and Price decides if firm will continue to produce or not. If price is below the AVC, then firm will shut down its output facility. It is called shutdown point.