Question

2) Explain how a profit-maximizing firm under perfect competition makes output decisions. [A full graphical and verbal presentation is required.]

Answer 1

A profit maximizing firm under perfect competition is a price taker, that is, it takes the market price as given. So, a profit maximizing perfectly competitive firm's demand curve = MR curve and it is horizontal at the market price level.

A firm under this condition, maximizes profit by producing at the point where price = MC in the short run. And, if in short run, at the profit maximizing quantity, price > ATC then, the firm will be earning super normal profit. This will attract other firms toward the industry. So, in long run, firms will enter the industry until in long run equilibrium each firm earns zero economic profit, i.e. produces at the point where price = minimum ATC.