What I don’t understand is how a company can maximize profits when marginal costs equal market price and marginal revenue because doesn’t it imply that producing an additional item costs them the same as its price and the revenue they would generate by selling it (meaning that they don’t make a profit)?
In: Economics
Included in the cost of production is the hourly wages of the employees, as well as facility expenses. If they break even, that means their employees and bills all got paid. So everybody involved made money, even if the company didn’t make profit.
Sounds like you are taking a business class. Good luck with that!
I think the concept you are struggling with understanding is “Marginal”.
A company is – in theory – at its most efficient when Marginal Revenue (MR) is equal to Marginal Cost (MC) (forget about market price).
This is because the company is squeezing ever cent of profit out of its products as possible.
Producing 1 unit less than where MR=MC leaves the opportunity to earn additional profits from that 1 unit of product, whereas producing 1 unit more than MR=MC means that that one additional (I.e. marginal) unit is not profitable.
Imagine how the total profit would look like on a graph with accumulated profit on the Y-axis and quantity on the X-axis. Total profit would have an upward slope until the point where MR=MC, after which total profits would slope downward again due to marginal costs exceeding marginal revenues.
Hope this helps. There are tons of videos on YouTube on the topic.
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Firms typically sell their products for a single price, even though the cost to make each product was different.
Consider a firm with increasing marginal costs. Producing the first 5 widgets costs $1 each. Producing the next 5 widgets costs $2 each. Producing the next 5 widgets costs $3.
Now suppose that in the competitive market, the market price for widgets is $2. For that 10th widget, marginal cost equals marginal revenue – both are $2. The firm will not make any money on the 6-10th widgets. However, the firm is ALSO selling the first 5 widgets for $2 each, despite the fact that they only took $1 to produce. Thus the firm earns a total profit of $5.
I simplified this explanation by making the 6th-10th widget all cost the same to produce, but if you imagine that the 9th widget actually cost slightly less than $2, and the 8th less than that, etc. you can see why the firm had an incentive to produce right up until the point that marginal revenue equaled marginal cost.
I also simplified this explanation by pulling a competitive market price out of nowhere. This is a bit of a cheat – competitive markets with easy-to-derive prices usually involve firms with fixed marginal costs. In that case, the firm doesn’t make any profits but may still choose to operate (we often think of “profits” as whatever comes above and beyond the owner’s potential earnings from working somewhere else). It’s possible to have both increasing marginal costs and firms without monopoly power, but the math is substantially more complicated.
You’re right, a perfectly competitive firm makes 0 profit, they earn exactly enough to cover their costs. 0 profit is the maximum profit they can earn as if they produce less they will not cover their costs and if they produce more the price will be too low and they will not cover their costs. In practice, this would include costs of financing so they would be able to get a market rate loan whenever they need to buy new equipment. Perfectly competitive firms are rare in the real world, probably the only example is industrial farming or mining. This is why farms typically get special support from the government to ensure national food production remains steady. Most companies will differentiate their product to some extent, which allows them to make a small profit even in a very competitive industry.
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