Question -
Answer -
The profit maximizing level of output is always determined where,
(i) MR = MC
(ii) MC must be rising. In other words, where price is equal to MC.
If price is not equal to MC, profit maximizing condition cannot hold. It can be explained with the help of the following two cases:
Case 1: Price Greater Than MC
(i) In the given figure at output level q2, the market price is greater than marginal cost.
(ii) To show that q2 is not a profit maximizing level of output, we have taken q3 output level, which is right of qr
(iii) Suppose the firm increases its output level from q2 to qr The increase in total revenue of the firm from this output is the market price multiplied by the change in quantity (ATR = market price x AQ), that is, the area of rectangle q2q3CB.
(iv) On the other hand, the increase in total cost with this, increase in output is the area of the region q2q3XW.
(v) But, a comparison of the two area shows that the firm’s profit is higher when output level is q3 rather than q1 So, q2 is not a profit maximizing level of output.
Case 2: Price Less Than MC
(i) In the given figure at output level q2, the market price is less than marginal cost.
(ii) To show that q2 is not a profit maximizing level of output, we have taken q3 output level, which is left of qr
(iii) Suppose now, that the firm reduce its output level from q2 to q1 The decrease in total revenue of the firm from this output is the market price multiplied by the change in quantity (ATR = market price x AQ), that is, the area of rectangle q2q3CB.
(iv) On the other hand, the decrease in total cost with this decrease in output is the area of the region q2q3WX.
(v) But, a comparison of the two area shows, that by reducing the output from q2 to q3, the decrease in cost is more than the loss in revenue. So, q2 is not a profit maximizing level of output.