DR.
SHAKUNTALA MISRA NATIONAL
REHABILITATION UNIVERSITY
LUCKNOW
ACADEMIC SESSION: 2020-2021
BUSINESS ECONOMICS
TOPIC: EQUILIBRIUM OF FIRM
SUBMITTED BY SUBMITTED TO
ANVESHA CHATURVEDI MRS. MALINI SRIVASTAVA
[Link].B. (HONS.) FACULTY OF LAW
3RD SEMESTER DR. SHAKUNTALA MISRA
NATIONAL REHABILITATION
UNIVERSITY, LUCKNOW
ACKNOWLEDGEMENT
In preparation of my assignment, I had to take the help and guidance of
some respected persons, who deserve my deepest gratitude. As the
completion of this assignment gave me much pleasure, I would like to show
my gratitude Mrs. Malini Srivastava Ma’am, for giving me a good
guideline for assignment throughout numerous consultations. I would also
like to expand my gratitude to all those who have directly and indirectly
guided me in writing this assignment
.
TABLE OF CONTENTS
INTRODUCTION
MEANING & DEFINITION OF FIRM
OBJECTIVES OF FIRM
CONDITIONS OF EQUUILIBRIUM OF FIRM
SHORT RUN EQUILIBRIUM OF FIRM
LONG RUN EQUILIBRIUM OF FIRM
BIBLIOGRAPHY
EQUILIBRIUM OF FIRM
INTRODUCTION:
A firm is in equilibrium when it has no desire to change
(increase or decrease) its output levels. At the equilibrium point, the firm earns
maximum profits. In this article, we will talk about the equilibrium of the firm along
with two approaches to the producer’s equilibrium.
MEANING & DEFINITION OF FIRM:
It is essential to know the meaning of
firm and industry before analyzing the two. Firm is an organization which
produces and supplies goods that are demanded by the people with the goal of
maximizing its profits.
According to [Link], “Firm is an organization that buys and hires resources
and sells goods and services.”
According to Lipsey, “Firm is the unit that employs factors of production to
produce commodities that it sells to other firms, to households, or to the
government.”
Objectives of the Firm
The primary objectives of a firm are:
Achieving a target rate of return
Stabilizing price and profit margins
Realizing a target market share
Preventing price competition
Maximizing sales or sales revenues
For a very long time, people believed that the sole objective of a firm is
maximizing profits. After all, every business wants to earn maximum profits.
However, over the years the belief changed. It is now believed that only in the case of
a single-owner firm is profit maximization the sole objective.
In today’s times, the
salary and perks of managers are related to the sales figures (not profit). Even
financial institutions readily provide credit to firms with increasing sales. This has led
to the realization of the target market share becoming an important objective of a
firm.
Conditions of Equilibrium of the Firm:
A firm is in equilibrium when it has no tendency to change its level of output. It
needs neither expansion nor contraction. It wants to earn maximum profits in by
equating its marginal cost with its marginal revenue, i.e. MC = MR .
Diagrammatically, the conditions of equilibrium of the firm are:
(1) The MC curve must equal the MR curve. This is the first order and necessary
condition. But this is not a sufficient condition which may be fulfilled yet the firm
may not be in equilibrium.
(2) The MC curve must cut the MR curve from below and after the point of
equilibrium it must be above the MR. This is the second order condition.’ Under
conditions of perfect competition, the MR curve of a firm coincides with the AR
curve. The MR curve is horizontal to the X- axis. Therefore, the firm is in
equilibrium when MC=MR=AR (Price).
In Figure 1(A), the MC curve cuts the MR curve first at point A. It satisfies the
condition of MC = MR, but it is not a point of maximum profits because after point
A, the MC curve is below the MR curve. It does not pay the firm to produce the
minimum output OM when it can earn larger profits by producing beyond OM.
Point В is of maximum profits where both the conditions are satisfied. Between
points A and B. it pays the firm to expand its output because it’s MR > MC. It will,
however, stop further production when it reaches the OM1 level of output where
the firm satisfies both the conditions of equilibrium.
If it has any plans to produce more than OM1 it will be incurring losses, for its
marginal cost exceeds its marginal revenue beyond the equilibrium point B. The
same conclusions hold good in the case of a straight line MC curve as shown in
Figure 1. (B)
Short-Run Equilibrium of the Firm:
A firm is in equilibrium in the short-run when it has no tendency to expand or
contract its output and wants to earn maximum profit or to incur minimum losses.
The short-run is a period of time in which the firm can vary its output by changing
the variable factors of production. The number of firms in the industry is fixed
because neither the existing firms can leave nor new firms can enter it.
Assumptions:
This analysis is based on the following assumptions:
1. All firms use homogeneous factors of production.
2. Firms are of different efficiency.
3. Cost curves of firms vary from each other.
4. All firms sell their products at the same price determined by demand and supply
of the industry so that the price of each firm, P (Price) = AR = MR.
5. Firms produce and sell different quantities.
The short-run equilibrium of the firm can be explained with the help of marginal
analysis and total cost- total revenue analysis.
(1) Marginal Cost-Marginal Revenue Analysis:
During the short run, a firm will produce only if its price equals the average
variable cost or is higher than the average variable cost (AVC). Further, if the price
is more than the averages total costs (SAC or АТС), i.e., P— AR > SAC, the firm
will be earning supernormal (or abnormal) profits.
If price equals the average total costs,
i.e., P = AR = SAC, the firm will be earning normal (or zero) profits or breaks-
even. If price equals AVC, the firm will be incurring a loss. If price falls even a
little below AVC, the firm will shut down because in order to produce it must
cover at least its AVC during the short-run.
So during the short-run under perfect competition, a firm is in equilibrium in all the
above noted situations. We illustrate them diagrammatically as under.
Supernormal Profits:
The firm will be earning supernormal profits in the short-run when price is higher
than the short-run average cost, as shown in Figure 2 (A). The firm is in
equilibrium at point E1 where SMC=MR and SMC cuts MR from below. OQ, is
the equilibrium output and OP (=Q1E1) is the equilibrium price. Q1S are the short-
run average costs.
SE1 (=Q1E1-Q1S) is the profit per unit. TS (equilibrium output) (per unit profit) =
TSE1P area is the supernormal profits.
Normal Profits:
The firm may earn normal profits when price equals the short-run average costs as
shown in Figure 2 (B). The firm is in equilibrium at point E2 where SMC =MR and
SMC cuts MR from below. OQ2 is the equilibrium output and OP (=Q2E) is the
equilibrium price. The firm is earning normal profits because Price = AR = MR
=SMC= SAC at its minimum point E2.
Minimum Loss:
The firm may be in equilibrium and yet incur a loss when price is less than the
short-run average costs, as shown in Figure 2 (C). The firm is in equilibrium at
point E3 where SMC = MR and SMC cuts MR from below. OQ3 is the equilibrium
output and OP (=Q3E3) is the equilibrium price.
Since the average costs Q3B are higher than the price Q3E3, E3B is the loss per unit
(Q3B-Q3E3). The total loss is PE3 x E3B = PE3BA. The firm will continue to
produce OQ3 output so long as it is covering its average variable cost plus some of
its fixed cost.
Maximum Loss:
If the price fig. 2 falls to the level of AVC, the firm will just
cover its average variable cost, as shown in figure 2 (D). It is indifferent whether to
operate or close down because its losses are the maximum.
It will pay such a firm to continue producing OQ4 output and incur PE4GF losses
rather than close down in the short-run. OQ4 is the shutdown output because if the
price falls below OP, the firm will stop production. E4 is, therefore, the shutdown
point.
Shut Down Stage:
Figure 2. (E) shows a firm which is unable to cover even its AVC at OQ0 level of
output because the price OP is below the AVC curve. It must shut down.
Thus in the short-run, there are firms which earn normal profits, supernormal
profits and incur losses.
(2) Total Cost-Total Revenue Analysis:
The short-run equilibrium of the firm can
also he shown with the help of total cost and total revenue curves. The firm is able
to maximize its profits when the positive difference between TR and TC is the
greatest. This is shown in Figure 3 where TR is the total revenue curve and TC the
total cost curve.
The total revenue curve is an upward sloping straight line curve starting from O.
This is because the firm sells small or large quantities of its product at a constant
price under perfect competition. If the firm produces nothing, total revenue will be
zero the more it produces, the larger is the increase in total revenue. Hence the TR
curve is linear and slopes upward.
The firm will maximize its profits at that level of output where the gap between the
TR curve and the TC curve is the maximum. Geometrically, it is that level at which
the slope of a tangent drawn to the total cost curve equals the slope of the total
revenue curve. In Figure 3, the maximum amount of profit is measured by TP at
OQ output.
At outputs smaller or larger than OQ between A and B points, the firm’s profits
shrink. If the firm produces OQ1 output, its losses are the maximum because the
TC curve is above the TR curve. At Q1 its profits are zero.
This is the break-even point of the firm. It starts earning profits when it produces
beyond OQ1 output level. At OQ2 level, its profits are again zero. If it produces
beyond this level, it incurs losses because TC > TR.
Long-Run Equilibrium of the Firm:
The long run is a period of time in which the firm can change its plant and scale of
operations. Thus in the long-run all costs are variable and there are no fixed costs.
The firm is in the long-run equilibrium under perfect competition when it does not
want to change its equilibrium output.
It is earning normal profits. If some firms are earning supernormal profits, new
firms will enter the industry and supernormal profits will be competed away. If
some firms are incurring losses, some of the firms will leave the industry till all
earn normal profits.
Thus there is no tendency for firms to enter or leave the industry because every
firm must earn normal profits. “In the long-run, firms are in equilibrium when
they have adjusted their plant so as to produce at the minimum point of their
long-run AC curve, which is tangent (at this point) to the demand (AR) curve
defined by the market price” so that they earn normal profits.
Assumptions:
This analysis is based on the following assumptions:
1. Firms are free to enter into or leave the industry.
2. All firms are of equal efficiency.
3. All factors are homogenous. They can be obtained at constant and uniform
prices. SMC
4. Cost curves of firms are uniform.
5. The plants of firms are equal, having given technology.
6. All firms have perfect knowledge about price and output.
Given these assumptions, each firm of the industry will be in long-run equilibrium
when it fulfils the following two conditions.
(1) In equilibrium, its short-run marginal cost (SMC) must equal to its long-run
marginal cost (LMC) as well as its short-run average cost (SAC) and its long-run
average cost (LAC) and both should equal MR=AR=P.
Thus the first equilibrium condition is:
SMC = LMC = MR = AR = P = SAC = LAC at its minimum point, and
(2) LMC curve must cut MR curve from below: Both these conditions of
equilibrium are satisfied at point E in Figure 5 where SMC and LMC curves cut
from below SAC and LAC curves at their minimum point E and SMC and LMC
curves cut AR = MR curve from below. All curves meet at this point E and the
firm produces OQ optimum output and sells it at OP price.
Since we assume equal costs of all the firms of industry, all firms will be in
equilibrium in the long-run. At OP price a firm will have neither a tendency to
neither leave nor enter the industry and all firms will earn normal profits .
BIBLIOGRAPHY
WEB SOURCES:
[Link]
competition/equilibrium-of-a-firm-under-perfect-competition-
microeconomics/15731
[Link]
competition/equilibrium-of-the-firm-and-industry-under-
perfect-competition/18579
[Link]
of-market/equilibrium-of-the-firm/
[Link]
competition/the-equilibrium-of-the-firm-under-perfect-
competition-explained/37112
