Equilibrium of a Firm under Perfect Competition | Microeconomics

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.

Under perfect competition, an individual firm has to accept price which is determined by industry. The firm under perfect competition is a price taker and not price-maker. Demand curve or average revenue curve of the firm is a horizontal straight line (i.e., parallel to X-axis).

Since perfectly competitive firms sell additional units of output at the same price, marginal revenue curve coincides with average revenue curve. To decide about its equilibrium output, the firm will compare marginal cost with marginal revenue. It will be in equilibrium at the level of output at which marginal cost is equal to marginal revenue and marginal cost curve cuts marginal revenue curve from below.

Consider the Fig. 8.1 in which price 0P is prevailing in the market. Marginal cost curve cuts MR curve at two different points E₀ and E₁ and marginal cost and marginal revenue are equal at these two points. E₀ cannot be the position of equilibrium since at E₀ second order condition of the firms equilibrium is not satisfied.

The firm can increase its profits by increasing production beyond E₀ because marginal revenue is greater than marginal cost. The firm will be in equilibrium at point E₁ or output 0Q₁ 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.

For the sake of simplicity of study, let us suppose that in an industry all factors of production, are homogenous. All the firms are equally efficient such as they have identical cost curve.

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 figuratively.

(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. 8.2 SAC and SMC are short run average and marginal cost curves of the firm. PP, is the average and marginal revenue curves, which 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 E connecting the X-axis at Q. EQ is the equilibrium price because point E lies on the demand curve, and price is determined by demand curve. Average cost is equal to CQ. Since average revenue is greater than average cost. Thus, firms per unit excess profit is EC which is the difference between price (EQ) and the corresponding average cost (CQ). Total supernormal profit of a firm is PECD.

(iii) 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. 8.3.

E is the equilibrium point because at this point MC = MR. MC curve cuts MR curve from below. 0Q is the equilibrium output. At 0Q 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. 8.4.

In the Fig. 8.4 marginal cost is equal to marginal revenue at point E. MC curve cuts MR curve from below. 0Q is the equilibrium level of output. Average revenue and average cost of the firm are equal to EQ and FQ, respectively. At 0Q level of output, firms average cost is greater than average revenue. Firm’s per unit loss is equal to EF and total loss is equal to area EFPG.

Now the question arises why the firm continues production even at losses. The reason being, in the short period fixed factors like machinery and plants cannot be changed. Therefore, if the firm stops production due to loss, then it will have to bear losses equivalent to fixed cost.

If the firm in the short period earns revenue which covers not only its average variable cost but also some part of fixed cost, the firm will continue its production.

In such circumstances, firm will incur more losses if it stops production. Therefore, it is better for the firm to continue to produce so long as it earns revenue more than or equivalent to minimum average variable cost, then firm will incur minimum losses. But when the firm’s price or average revenue falls below minimum average variable cost the firm will prefer to discontinue its production. The firm can avoid cost of variable factors of production.

The above argument has been elaborated by the Fig. 8.4. When price is 0P then firm’s equilibrium is at point E and it will produce 0Q level of output. The firm experiences loss equivalent to area FEPG The firm will continue its production in such situation, because price is greater than minimum average variable cost.

If the price of the commodity is 0P₁ then the equilibrium of the firm will be at point E and price is equivalent to minimum of average variable cost.

At point E₀, the firm is covering its minimum average variable cost. But at this point no part of fixed cost is being covered. Therefore, the loss of firm is equivalent to total fixed cost, at 0Q₀ level of output Point E₀ is known as ‘shut down point’. If price falls below 0P₁ then production will be stopped because firm’s loss is more than total fixed cost.

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 complete 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. 8.5 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.

The firm will get only normal profits because at point E, LAC curve is tangent to AR curve.

If price is increases from 0P to 0P₁ where the firm is earning abnormal profits. There will be tendency for new firms to enter and compete away these abnormal profits. The firms cannot be in long-run equilibrium at any price higher than 0P.

On the contrary, if price declines from 0P to 0P₂ then price will be less than marginal cost, and consequently the firms will incur losses. Some of existing firms will quit the industry due to which supply of the commodity will decline. The price will increase due to decrease in supply. In the long- run, the equilibrium of the firm will be at 0P price because firm will get only normal profits at the price.

Equilibrium of Industry under Perfect Competition:

The industry will be in equilibrium when industry has no tendency to either increase or decrease its level of output. An industry is said to be in equilibrium when industry is no tendency for it to expand or contract. It means demand for the product of industry and supply of it are in equilibrium. The industry has no tendency to vary its output.

If at a prevailing price, demand for the commodity is more than supply, the industry will try to expand its output. On the other hand, if at prevailing price, quantity demanded of a product falls short of quantity supplied, the price and output of the industry will tend to fall.

When demand for the commodity is equal to supply of commodity, then industry will have no tendency to vary its output. Thus, we conclude that industry will be in equilibrium at that level of price end output, where demand curve and supply curve intersect each other.

Conditions of Equilibrium of the Industry:

For the industry to be in equilibrium following three conditions should be fulfilled:

(i) Demand for and supply of product of the industry must be equal.

(ii) All the firms in the industry should be in equilibrium.

(iii) There should be no tendency to change the number of firms in the industry, i.e., the firms are earning only normal profits.

Short Run Equilibrium of the Industry:

In the short run, new firms can neither enter in the industry nor the old firms exit from the industry. Therefore, industry will be in equilibrium when above given first two conditions are fulfilled. The short-run equilibrium of industry has been shown in the Fig. 8.6.

In part A of the Figure, the equilibrium of the industry has been shown. Demand curve and supply curve of the industry intersect each other at point E. 0P is the equilibrium price and 0Q is the equilibrium output.

The firm will take 0P price as given and adjust its output in such a way that it may earn maximum profit. In part B of the diagram equilibrium of the firm has been shown. E₀ is the firm’s equilibrium. 0M is the equilibrium output. Average revenue and average cost are equal to E₀M and CM, respectively.

Since average revenue is greater than average cost, the firm is earning super normal profit equal to area EoCGP. Suppose; cost of all the firms are identical, all the firms are earning normal profit. If the demand for the product declines, the price of the product will also decline and the equilibrium will be at lower level of output. The industry will be in equilibrium, although firms might be incurring losses.

In this case too the industry will be in short-run equilibrium.

Long-Run Equilibrium of the Industry:

Long run is that period of time under which new firms can enter and old firms can leave the industry. If firms in the industry are earning super normal profits, new firms will enter in the industry. On the other hand if the firms in the industry are incurring losses, then some existing firms will leave the industry.

Therefore, the industry will be in equilibrium, when above given conditions are fulfilled.

In part A of Fig. 8.7, industry equilibrium is shown. E is the equilibrium point. 0P and 0Q are the equilibrium level of price and output. The firms will adjust their output in such a way that it may earn maximum profits. In part B of Figure, equilibrium of the firm has been shown.

0M is the equilibrium level of output. The firm will get only normal profits because LAC curve is tangent to AR curve at equilibrium level of output 0M. If cost curve of all the firms are identical all the firms in the industry will earn only normal profits. Under these circumstances, there will be no tendency for the firms to enter or leave the industry.