Equilibrium of Firm

A firm is said to be in equilibrium when it has no tendency either to increase or to contract its output. A firm is in equilibrium when it is earning maximum profit.

Conditions of Equilibrium

A firm would be in equilibrium when the following two conditions are fulfilled :

  1. MC = MR
  2. MC curve cuts MR curve from below.

In perfect competition there is an assumption for equilibrium state i.e. All firms sell their products at the same price determined by demand and supply of the industry so that the price of each firm is equal to AR = MR.

Consider the Fig. I in which price OP is prevailing in the market. Marginal cost curve cuts MR curve at two different points Eo and E1 and marginal cost and marginal revenue are equal at these two points. Eo cannot be the position of equilibrium since at Eo second order condition of the firms equilibrium is not satisfied.

The firm can increase its profits by increasing production beyond Eo because marginal revenue is greater than marginal cost. The firm will be in equilibrium at point E1 or output OQ1 since at E1 marginal cost equals to marginal revenue as well as marginal cost curve cuts marginal revenue curve from below.

Equilibrium of the firm in the short period

Short run means period of time within which the firms can alter their level of output only by increasing or decreasing the amount of variable factors such as labour and raw material, while fixed factors like capital equipment remain unchanged. Moreover, in the short run, new firms can neither enter the industry nor the existing firms can leave it.

Under the circumstances each firm of a given industry, in equilibrium may get either.

i) Super normal profit.

ii) Normal profit.

iii) Suffer losses

All the three situations depend upon the price determined by the industry.

All the three situations faced by the firms in equilibrium in short run are explained diagrammatically.

i) Equilibrium with Super Normal Profits: A firm is in equilibrium when its marginal cost is equal to marginal revenue and marginal cost curve cuts marginal revenue curve from below.

A firm in equilibrium earns super normal profits, when average revenue (Price) determined by industry is more than its average cost. In the Fig. 2 AC and MC are short run average and marginal cost curves of the firm.

The average and marginal revenue curves are parallel to X-axis. The reason being, under perfect competition, firm is a price taker not price maker. The firm’s equilibrium will be at point E.

A perpendicular parallel to the Y-axis is drawn at point P connecting the X-axis at Q. OP is the equilibrium price and OQ is the equilibrium quantity Average cost is equal to GQ. Since average revenue is greater than average cost.

Thus, firm’s per unit excess profit is EG, which is the difference between price (EQ) and the corresponding average cost (GQ). Total supernormal profit of a firm is PEHG.

(ii) Equilibrium with Normal Profit In the short period, it is possible that firm earns only normal profit. This happens only when the average cost curve of the firm is tangent to its average revenue curve. Equilibrium of the firm has been explained in the Fig.

E is the equilibrium point because at this point MC = MR. MC curve cuts MR curve from below. OQ is the equilibrium output. At OQ level of output the firms AC curve is tangent to AR curve. Thus the firm will earn only normal profit because average revenue (EQ) being equal to average cost (EQ).

(iii)Equilibrium with Losses

A firm in equilibrium may incur losses when at the equilibrium level of output firm’s average cost is greater than average revenue. The equilibrium of the firm can be explained with the help of Fig.

In the Fig. marginal cost is equal to marginal revenue at point E. MC curve cuts MR curve from below. OQ is the equilibrium level of output. Average revenue and average cost of the firm are equal to EQ and GQ respectively.

At OQ level of output, firms average cost is greater than average revenue. Firm’ s per unit loss is equal to EG and total loss is equal to area EPHG.

Shut-Down Point

When the firm’s average total cost curve lies above its marginal revenue curve at the profit maximizing level of output, the firm is experiencing losses and will have to consider whether to shut down its operations. In making this determination, the firm will take into account its average variable costs rather than its average total costs. 

The difference between the firm’s average total costs and its average variable costs is its average fixed costs. The firm must pay its fixed costs (for example, its purchases of factory space and equipment), regardless of whether it produces any output.

Hence, the firm’s fixed costs are considered sunk costs and will not have any bearing on whether the firm decides to shut down. Thus, the firm will focus on its average variable costs in determining whether to shut down.

If the firm’s average variable costs are less than its average revenue at the profit maximizing level of output, the firm will not shut down in the short‐run. The firm is better off continuing its operations because it can cover its variable costs and use any remaining revenues to pay off some of its fixed costs.

The fact that the firm can pay its variable costs is all that matters because in the short‐run, the firm’s fixed costs are sunk; the firm must pay its fixed costs regardless of whether or not it decides to shut down.

Of course, the firm will not continue to incur losses indefinitely. In the long‐run, a firm that is incurring losses will have to either shut down or reduce its fixed costs by changing its fixed factors of production in a manner that makes the firm’s operations profitable.

Shut- Down point       –     AR= AVC

Losses                         –     AR < AVC

Long-Run Equilibrium of the Firm

The long run is a period of time which is sufficiently long to allow the firm to make changes in all factors of production. The firms in the long run, can increase their output by changing their capital equipment, they may expand their old plant or replace the old lower capacity plants by the new higher capacity plant.

Besides, in the long run new firm can enter the industry to compete with existing firm.

The long run equilibrium refers to the situation where free and full adjustment in the capital equipment as well as in the number of firms has been allowed to take place.

A firm is in equilibrium under perfect competition when MC = MR and MC curve must cut MR curve from below. But for the firm to be in long run equilibrium, besides the equality of MC and MR, there must be equality of AR and AC.

In other words, the firm will get only normal profits. If the price is greater than the average cost, the firms will earn super normal profits. The supernormal profits will attract other firms into the industry.

The price of the product will go down as a result of increase in supply of output and the cost will go up as a result of more intensive competition for factors of production. The firms will continue entering into the industry until the price is equal to average cost so that all firms are earning only normal profits.

On the contrary, if the price is lower than the average cost, the firm would make losses. These losses will induce some of the existing firms to quit the industry. Supply of output will decrease and price will increase because of increase in the average cost. Thus, the firms will get only normal profit, in the long run.

From this analysis we conclude that for the firm to be in equilibrium in the long run following two conditions should be fulfilled.

(i) MC = MR and MC curve must cut MR curve from below.

(ii) Average Revenue must be equal to average Cost (AR = AC).

Because in the perfect competition, AR = MR, the above the condition can also be written as:

Price = AR = MR = LMC = LAC.

Price = LMC = LAC

The relationship MC and AC also reveals that MC curve cuts AC curve at its minimum point.

These, conditions for long run equilibrium of the firm can also be written as:

Price = MC = Minimum Average Cost

The Fig represents long run equilibrium of firm under perfect competition.

LAC and LMC are the long run average and marginal Cost curves, respectively. The firm will be in equilibrium at point E, at which marginal Cost is equal to marginal revenue and marginal Cost curve is rising.

Powered By 360Presence

Project Time Cost Trade-off Project Time Cost Trade-off Project Time Cost Trade-off Project Time Cost Trade-off

By Hassham

Leave a Reply

Your email address will not be published. Required fields are marked *