The model
A perfectly competitive market has many small sellers, an identical product, and free entry and exit. Each firm is a price taker: it cannot influence the market price, so it can sell any amount at that price. Wheat and basic commodities approximate this model. For the firm, marginal revenue equals the market price.
The profit-maximising rule
A firm maximises profit by producing the quantity where marginal revenue equals marginal cost. In perfect competition MR = P, so the rule is P = MC. If MC is below P, an extra unit adds more to revenue than to cost, so produce more. If MC is above P, cut output.
Profit and loss
Profit per unit is P − ATC, so total profit is (P − ATC) × Q.
Worked example 1. The market price is 8 dollars. At the output where MC = 8, which is 100 units, ATC is 6. Profit = (8 − 6) × 100 = 200 dollars.
Worked example 2. The price falls to 5 dollars. At the output where MC = 5, which is 100 units, ATC is 6 and AVC is 4. Profit = (5 − 6) × 100 = −100, a loss of 100. Should the firm shut down?
- Fixed costs equal (ATC − AVC) × Q = (6 − 4) × 100 = 200, and must be paid even at zero output.
- If it operates, it loses 100. If it shuts down, it loses 200.
- Price (5) is above AVC (4), so each unit covers its variable cost and contributes 1 toward fixed costs.
So the firm should keep operating in the short run. The shutdown rule: produce if P is at least AVC; shut down if P is below AVC.
Long-run equilibrium
If firms make positive economic profit, new firms enter, supply shifts right, the price falls and profit shrinks. If firms make losses, firms exit, supply shifts left and price rises. This continues until the price equals the minimum of ATC and economic profit is zero. In the long run, perfect competition therefore achieves productive efficiency (lowest cost) and allocative efficiency (P = MC, so the value of the last unit equals its cost).
Remember "zero economic profit" does not mean the owners earn nothing: they earn the normal return that they could get elsewhere.