In this article we will discuss about how to attain equilibrium of a firm under perfect competition.
Equilibrium of a Firm under Perfect Competition:
An individual firm is called in equilibrium when two conditions are met:
(1) The change in output does not encourage the firm.
(2) When the firm is earning maximum profit.
There are two methods of knowing that a firm is in equilibrium. They are:
(1) Total revenue and total cost method.
(2) Marginal revenue and marginal cost method.
1. Total Revenue and Total Cost Method:
A firm is called in equilibrium on the basis of TR and TC method when two conditions are attained.
(1) There should be maximum difference between TR and TC at the equilibrium output. It can be possible only when the rate of change in TR and TC are the same.
(2) When the TR is greater than TC or equal at the equilibrium output.
With the help of TR and TC methods we can explain the equilibrium of a firm as given in the diagram:
In the diagram output is shown on OX-axis is and total revenue (TR) and total cost (TC) on OY-axis. E and E2 points are breakeven points showing OQ and OQ2 level of output where total revenue is equal to total cost (TR=TC). The firm is neither earning profit nor incurring losses. The maximum difference between total revenue and total cost is at point E1 where volume of output is OQ1.
Before OQ and OQ2 the total cost is greater than total revenue and there will be loss to the firm. Hence the equilibrium output of the firm is OQ1 where the maximum difference is between E1F and the firm will earn maximum profit.
2. Marginal Revenue and Marginal Cost Method:
The equilibrium of a firm can also be studied with the help of its marginal revenue and marginal cost methods.
According to this method a firm may be called in equilibrium when two conditions are met as given below:
(1) The firm will be in equilibrium when its MR is equal to its MC (MR=MC).
(2) The another sufficient condition is that the marginal cost curve (MC) of the firm must cut its marginal revenue curve (MR) from its below.
The equilibrium of the firm with the help of MR and MC method can be explained with the following diagram:
Output is shown on OX-axis, price, cost and revenue are shown on OY-axis. Price is equal to average revenue and marginal revenue (P=AR=MR) is the demand curve of the firm which is horizontal to OX-axis because of the uniform price prevailing under perfect market, MC is the marginal cost curve of the firm. It is U-shaped because of the operation of laws of returns. Marginal revenue is equal to marginal cost (MR=MC) at two points E and E1 where the output is OQ and OQ1.
The first condition is met at both the points but the second condition is met at point E1 only with OQ1 output. After point E the cost is decreasing and it is in the interest of the firm to carry on production. But after point E1 it is not in the interest of the firm to carry on production because MC increases. Hence, the sufficient condition of equilibrium is the E1 point with OQ1 output.
The second method (MR and MC Method) is used for the calculation of profit and knowing the equilibrium of the firm in any type of market structure during short run and long run because in the TR and TC method the difference between the two cannot be easily measured.
Short period is that type of period during which a firm can increase the supply of a commodity by increasing the variable factors of production, namely, labour, raw material, power etc., while fixed factors of production cannot be increased. The supply can be increased through variable inputs and to the extent maximum utilisation of its installed capacity.
There will be neither entry of new firms nor the old firms are in a position to leave the industry during this period. The firm will be in the equilibrium where its marginal cost is equal to its marginal revenue (MC=MR).
A firm can have four situations when it is in equilibrium under perfect competition during short period as given below:
(1) Profit Situation:
During short period a firm will earn profit when its average revenue is higher than the average cost (AR>AC) at the equilibrium point. The profit situation is also called abnormal profit situation or super normal profit.
This situation can be seen from the following diagram:
Price, short run average cost (SAC) and short marginal cost (SMC) are shown on OY-axis and average revenue and marginal revenue by SAR and SMR on the same axis while output is shown on OX-axis. The point of equilibrium of the firm is at point E where the short run marginal cost is equal to short run marginal revenue (SMS=SMR). The price is OP and the amount of output is OQ. Cost curves are below the revenue curves so the firm is earning profit. In the diagram we see that-
OP is price
OQ is output
ES is average profit (AR-AC)
PLSE is total profit (ESxOQ)
(2) Normal Profit Situation:
When the firm attains its equilibrium at the profit where its average revenue is equal to its average cost (AR=AC) the situation is called normal profit.
It can be seen from the following diagram:
Price, revenue and cost are shown on OY-axis and output on OX-axis. The point of equilibrium is at point E where SMC curve is equal to SMR the price is OP and output is OQ. At point E short run average revenue is equal to short run average cost, short run marginal revenue is equal to short run marginal cost CP=SAR=SAC=SMR=SMC. The firm is earning normal profit and at the same time firm is also called optimum firm during short run.
(3) Loss Situation:
When the average cost of a firm is greater than its average revenue at the point of equilibrium during short period the situation is called loss situation. Cost curves will be above revenue curves. It can be seen from Diagram 6.
Output is shown on OX-axis and price, revenue and cost on OY-axis in the diagram. Price is OP, output is OQ, the avenge loss (SAC=SAR) is equal to SE and the total loss is equal to LPES (SExOQ).
(4) Shut Down Point Situation:
During short period, under perfect competition neither the new firms will enter nor old firms will leave the industry. A firm will continue its production till the point where it is meeting its variable cost of production but if the firm’s average revenue is less than its average variable cost (AR>AVC) then it is in the interest of the firm to slop the production so at least the loss will be equivalent to its fixed cost only.
This situation is called shut down point of the firm as given in the following diagram:
The diagram shows output on OX-axis while price, revenue and costs are shown on OY-axis. SMC is short run marginal cost, SAC is short run average cost and AVC is average variable cost, AR and MR are average revenue and marginal revenue curves respectively. The shutdown point is that point where the price is below the variable cost and as soon as firm attains this point the firm should stop the output so that the firm may bear loss equivalent to fixed cost only.
When the price is OP the firm is incurring loss equal to MPEL at E point of equilibrium. When the price is OP1 the output is OQ1 and equilibrium of the firm is at E1. At this point (E1) firm is meeting average variable cost and if the price is reduced to OP2 then the firm has to close its door. Thus, E is the shutdown point of the firm because the price is equal to average variable cost (P=AVC). At point E1 the firm is not meeting its fixed cost but it is meeting its variable cost.
Under perfect competition if the firms are earning profits during short run the firms will be attracted to enter the industry during long period. Number of firms will increase. Output will increase. Price will decrease and profit will decrease leading to normal profit situation of the firm. If the firms are incurring losses during short period the firms will leave the industry during long period.
Number of firms will decrease. Output will decrease. Price will increase and loss making situation will be converted into normal profit situation. Thus, the firm during long period under perfect competition will earn normal profit only.
It can be seen from the following diagram:
The diagram shows price, costs and revenue of equilibrium of the firm is at E point where long run marginal cost curve cuts the long run marginal revenue curve. The price is OP and output is OQ. At point E price is equal to long run average revenue, average cost, long run marginal revenue and marginal (P=LAR=LAC=LMR =LMC). The firm is earning normal profit and it is called an optimum firm during long period.