Short-Run Profit Maximization

A competitive firm is a price-taker, able to sell as little or as much as it desires at the going market price. In other words, demand for a competitive firm is perfectly elastic at the going price. Its only choice, then, is how much output, if any, to produce. Throughout, firms are assumed to maximize profits.

Exploration: With respect to its output choice, what is the rule a competitive firm will follow to obtain maximum profits?

The graph shows the average- and marginal-cost curves of a typical competitive firm. Initially, price is $80 and the firm is producing 80 units per week. Its fixed costs are $2700 per week. To use the graph, click and drag the green triangle on the vertical axis to change the market price, hence the firm's demand curve. Click and drag the magenta triangle on the horizontal axis to change the firm's choice of output. Cost and profit data are shown in the box at right; clicking on the Show Profit/Loss button will provide a graphical illustration of the firm's profit or loss, profit in green and losses in red. Clicking the Reset button will restore all initial values.

1. At the initial market price of $80 and output level of 80 units per week, how much profit is the firm earning? Is there any other output choice that provides a higher profit?
   
   
2. Holding price constant at $80, compare price and marginal cost at various output levels. How should the firm adjust its output if price exceeds marginal cost? How should the firm adjust its output if price falls short of marginal cost?
   
   
3. Suppose price rises to $100. How should the firm respond? Will its profits increase or decrease?
   
   
4. If price suddenly falls to $60 per week, should the firm shut down?
   
   
5. Experiment on your own. What is the rule for profit maximization?

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Exercise picked up from the 2e Microeconomics textbook.