Final answer:
In perfect competition, firms produce the quantity where marginal cost equals price to maximize profits and achieve allocative efficiency. This condition also indicates if the firm is making profits or losses based on the relationship between market price and average cost.
Step-by-step explanation:
A firm in perfect competition will produce the quantity at which marginal cost (MC) equals the price (P) to maximize profits. The reason is that marginal revenue in perfect competition is equal to the price of the product, which means profit-maximization occurs where P = MC. This condition also ensures that the firm is producing at an efficient level where the benefits to consumers are equivalent to the society's costs of producing the marginal units, thus achieving allocative efficiency.
When the market price is above average cost at the profit-maximizing quantity of output, the firm makes profits. Conversely, if the market price is below average cost at this quantity, the firm incurs losses. Therefore, firms in perfect competition respond to prices by adjusting output to ensure marginal revenue equals marginal cost.