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Economic profit for firms in perfectly competitive markets

An important skill in microeconomics is the ability to find a firm's profit. Learn more about how to use a graph to identify the profit-maximizing quantity for a firm in a perfectly competitive market, and identify the area that represents the firm's profit or loss.

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Video transcript

- [Instructor] In this video, we're going to dig a little bit deeper into the notion of perfectly competitive markets, or we're gonna think about under what scenarios a firm would make an economic profit or an economic loss in them. Now as a reminder, these perfectly competitive markets are something of a theoretical ideal. There's few markets in the real world that are truly perfectly competitive. Some might get close, but most markets are someplace in a spectrum between perfectly competitive and at the other extreme, say something like a monopoly. But here we're talking about perfect competition, and in perfect competition, the firm's products aren't differentiated. There's no barriers to entry or exit. And so in that situation, the market supply and demand curves are gonna define the price in the market, which are also gonna define the marginal revenue for these firms. They're all going to be price takers. They're gonna be passive in terms of price. Whatever the market price is, that's the price that they are going to sell their products for. And their decision is really what quantity to produce and sell and whether to enter or exit the market. So let's look at that a little bit. So these are just your classic and supply demand curves, supply and demand curves, you might see for a market. The first few units in the market, there's a huge marginal benefit. So people are willing to pay a lot, but then each incremental unit, the marginal benefits a little bit lower and lower and lower and lower, and that's why we have that downward-sloping demand curve. And then on the supply curve, the first unit in the market might be fairly inexpensive to produce, but then the marginal cost gets higher and higher and higher. And where they meet, where the supply and demand meet, that tells us the equilibrium price and equilibrium quantity in the market. And we can show that with that line, and let's just say that equilibrium price is $10. And as I just mentioned, that's going to have to be the price that all of the firms, and these might not be all of the firms in the market, but all of the firms in the market, if we're talking about a perfectly competitive market, would just have to take that price. So given that, what quantity would firms A, B, and C produce, and which of these firms would be profitable or not? I encourage you to pause the video and think about those two questions. If you could just answer, which of these firms would be profitable or not, and we're talking about economic profit in this context. All right, well let's look at Firm A first. Well Firm A, for any of them, it is not rational to produce a quantity where the marginal cost is higher than the marginal revenue that the firm's getting. And remember, this line right over here, this line right here, which is the price line, that's also, that is price, which is equal to marginal revenue. And so, for that extra unit, if you can't sell it for more than you're producing, then you wouldn't produce that extra unit. So it's rational for them to produce more and more and more, the marginal cost goes higher and higher, until right at the point that marginal cost is equal to marginal revenue, which is equal to price, the market price, which they're just going to take. So it's rational for this firm to produce this quantity right over here. So I'll just go quantity, I'll say quantity for that firm. Now is this firm going to be profitable or not? Well at this quantity, what's its average total cost? Well its average total cost is right over there, and so, for every unit, it's going to make this difference between the price or the marginal revenue it's getting and its average total cost. And so one way to thing about the profit of this firm is, and we're talking about economic profit, it's going to be the area of this rectangle right over here. So let's say if the average total cost at that quantity is, let's say that this is $8, then this height of the rectangle is 10 minus eight. The height right over here, let me do this in a different color, this height right over here is $2. And then the width is going to be the quantity of that firm. And so let's say the quantity of that firm, let's say it's 10,000 units a year, 10,000, 10,000 units per year. And so the area right over here would be $2 times 10,000. It would be $20,000. $20,000 per time unit if we're talking all of this is say per year. Now let's go to Firm B. Using that same analysis, is Firm B making an economic profit, or is it not making an economic profit? Well, Firm B is once again going to be a price taker, and so the price right over here, the equilibrium price in the market, is going to be equal to the price that that firm has to take, which is going to be its marginal revenue curve. And that's why it's a flat marginal revenue curve because no matter what quantity they produce, they're gonna get that same price. And it wouldn't be rational for them to produce a quantity where marginal cost is higher than marginal revenue. And so they would produce right over there. Now what is their economic profit at this quantity? So this is quantity of the second firm, Firm B, I'll write it like that, maybe that is Firm A. And maybe this is also, it looks about the same. I'll make 'em a little bit different. Let's say that's 9,500 units per time period. Well here the average total cost at that quantity is equal to the marginal cost. So, which is equal to the marginal revenue. So, at that quantity, whatever that $10 they're getting per unit, they're also spending on average $10 per unit. Another way to think about it, the area of that rectangle is going to be zero because it has no height. So this situation right over here, the firm has zero, zero economic, I'll write $0 of economic profit. And then last but not least, let's think about Firm C. Pause this video and think about what its economic profit would be. Well, like we've seen, it would be rational for it to produce the quantity where marginal cost is equal to marginal revenue, which is equal to the market price. So it would produce this quantity right over here. And let's say that that quantity is 9,000 units. And what's its average total cost then? So at 9,000 units, its average total cost, let's say that that is $12 right over there. So what's its economic profit? So for every unit it's selling, it's getting $10, and it's costing $12 on average to produce it. So it's taking an economic loss of $2 per unit. So $2 per unit, so this height right over here is $2, times the units, times 9,000, you're going to have two times 9,000, you're going to have an $18,000 not economic profit, but economic, economic loss. Now one thing to think about is, why would any firm be in this situation? Well it's important to think about things in the short run versus the long run. In the short run, we've talked about this analysis right over here where a firm can decide what quantity it would produce that is rational. Its fixed costs are fixed in the short run. We've studied that in multiple videos. But in the long run, its fixed costs aren't fixed, and so the firm could decide to enter or exit the market. And so for Firm C, while they've already put in those fixed costs, it is actually rational for them to do it because they're actually able to make the marginal revenue they get up to that quantity. It's at least they're able to more than cover their marginal costs, and then they're able to eat up or I guess you could say take care of some of their fixed costs. But they're still not able to run an economic profit. So in the long run, it wouldn't be rational for this firm to stay in the market. They would likely exit the market.