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Profit Maximization in Perfect Competition

Firms have to know not only about costs but also about revenues when they make pricing and output decisions. To understand, for instance, the relationship between output, revenues, and price, a firm has to know the structure of the market or industry in which it is selling its product. There are various market structures, all dependent upon the extent to which buyers and sellers can assume that their buying and selling decisions do not affect their price. At one stage, when buyers and sellers correctly assume that they cannot affect the market price, the market structure is one of perfect competition. However, when actors in the market must consider how their actions affect the market price, the market structure is termed as imperfectly competitive. Thus, this paper analyzes how a firm acting within a perfectly competitive market structure can maximize its profit.

Before we go ahead with the analysis, it is appropriate to outline the characteristics of a perfectly competitive market structure which act as assumptions for our conclusions. These are 1. The product that is sold by the firms in the industry is homogeneous. 2. Any firm can enter or exit the industry without any serious impediments. 3. There must be a big number of participants in the market who do not influence the price individually, and 4. There must be complete information. Both buyers and sellers must know about market price, product quality, and cost conditions (Maurice & Thomas, 2008). In essence, a perfectly competitive firm is such a small part of the total industry in which it operates that it cannot significantly affect the product in question (Maunder et al., 2000).

From the definition of a perfect competitor, a firm has to accept the given price of the product. If the company increases its price, it sells less. If it decreases its price, it makes less profit. The only decision variable left is: how much should it produce? The variants of this question include, what will be produced? How will it be produced? And who will get what is produced? Answering these questions ensures that a firm sells its wants without having to change the price thus the efficiency of perfect competition (Case & Fair, 1999). More so, a firm must adopt a profit maximization model to address these questions. It is assumed that, whether competitive or monopolistic, firms will attempt to maximize their total profits, that is, the positive difference between total revenues and total costs.

Therefore, a firm operating under perfect competition can sell its wants without any price change due to several strategies that apply to this market structure. Firstly, efficient distribution of resources among firms enables a firm to produce its products using the best available, that is, the lowest cost technology. To maximize profit, a firm must reduce the cost of manufacturing its preferred level of production. With full knowledge of technologies, a firm will select the technology that produces the output it needs at the least cost. A firm will employ additional production efforts provided that its marginal revenue product is above the market price. Thus, the assumption that factor markets are competitive and open, that all firms maximize their profits leads to the conclusion that the distribution of resources among firms is efficient. Secondly, a firm should consider the efficient distribution of its wants. The product must be able to get to the right people through proper channels of distribution that are less expensive. According to Case and Fair (1999), open competitive factor markets guarantee that firms don’t use wrong inputs, open, competitive output markets ensure that consumers don’t purchase unworthy products. Since customers are free to choose among the available goods and services, a firm must be able to ensure that its products are readily available in the market to sell.

Thirdly, a firm should be able to have an efficient mix of output. Producing what the customers want increases a firm’s sales level. The situation which ascertains that the right products are produced is P = MC. This implies that a firm operating in a perfectly competitive market will produce at an instance where the price of its output is the same as its marginal cost of production; both in the short and long period. In essence, when a firm measures price and marginal cost, it evaluates the value of its items to society at the margin against the value of the things that could otherwise be produced with the same resources (Maurice & Thomas, 2008). Lastly, a firm may opt to differentiate its products from other competing firms. This may involve adding a set of meaningful and valued differences to distinguish the firm’s products and services from those of competitors (Kotler, 2003).

In conclusion, a perfectly competitive firm does not have the power to influence the market price and thus, the only option is to look for ways to maximize its profit. This paper has discussed the conditions of a perfectly competitive market structure, including the homogeneous products being sold in the market, entry, and exit from the market as open, large numbers of buyers and sellers, and that there is complete information. In this system, efficient allocation of resources, an efficient mix of output, efficient distribution, and differentiation enable a firm to sell its wants without having to change the price.

References

Case, K.E. & Fair, R.C. (1999). Principles of Economics. 5th Ed. New Jersey: Prentice Hall.

Kotler, P. (2003). Marketing Management. Millennium Edition. New York: Prentice Hall.

Maunder, P., Myers, D., Wall, N., & Miller, R. (2000). Economics Explained. London: HarperCollins Publishers.

Maurice, S. & Thomas, C. (2008). Managerial Economics. 9th Ed. New York: McGraw-Hill.