Chapter 8: Problem 15

What prevents a perfectly competitive firm from seeking higher profits by increasing the price that it charges?

Short Answer

Expert verified

In a perfectly competitive market, firms are price takers and have no control over the prices of their homogeneous products. If a firm attempts to increase its price above the market price, consumers will purchase the good from other firms offering it at the market price, leading to unsold inventory and losses for the price-increasing firm. Therefore, firms in a perfectly competitive market cannot seek higher profits by raising their prices and must focus on maximizing profits by equating their marginal cost to their marginal revenue.

Step by step solution

Understand the characteristics of a perfectly competitive market

A perfectly competitive market is one where there are a large number of small firms producing a homogenous good. These firms have no control over the price, and new firms can freely enter or exit the market with no barriers. Consumers have perfect information about the quality and prices of the goods being offered.

Analyze the pricing strategy of a firm in a perfectly competitive market

In a perfectly competitive market, firms are price takers, meaning they have to accept the prevailing market price for their product. The market price is determined by the forces of supply and demand, at which the quantity demanded equals the quantity supplied. Each firm can sell any amount they want at the market price, but they have no control over that price.

Explain what happens when a firm tries to raise its price in a perfectly competitive market

If a firm tries to raise its price above the market price, consumers will choose to purchase the same product from other firms offering it at the market price because the good is homogeneous. The firm that raised its price will experience a large drop in the quantity demanded for its product, which would lead to unsold inventory and losses. Thus, any attempt to increase the price would result in a significant decrease in their sales, preventing them from earning higher profits.

Understand that firms in a perfectly competitive market maximize profit at the point where marginal cost equals marginal revenue

In a perfectly competitive market, the firm's profit maximization condition is where the marginal cost (MC) of producing an additional unit of the good is equal to the marginal revenue (MR) derived from selling that unit. This means that the firm will continue to produce and sell until MR=MC because any additional production beyond this point will increase costs more than it will increase revenue, thus decreasing total profits.

Conclusion

In a perfectly competitive market, firms are unable to seek higher profits by increasing their prices because any attempt to raise the price above the market price will result in consumers choosing to purchase the good from competing firms. Therefore, firms must accept the prevailing market price and focus on maximizing profits by equating their marginal cost to their marginal revenue.