Question

(b) Using an appropriate diagram, demonstrate how a perfectly competitive firm achieves equilibrium in the short-run. [7 marks]

Answer 1

Equilibrium of a Competitive Firm in the Short Run:

The fundamental objective of any business firm is the maximization of profit and minimization of cost, irrespective of the time period under consideration. Profit becomes maximum only when a firm reaches equilibrium, which is a point of no profit, no loss.

A firm will reach equilibrium when the following two conditions are fulfilled simultaneously:

i) Marginal Cost (MC) = Marginal Revenue (MR).

This is the necessary condition or first- order condition for equilibrium, and

(ii) Marginal Cost curve must cut Marginal Revenue curve from below, or slope of MC > slope of MR.

This condition is known as the sufficient condition or second-order condition.

A perfectly competitive firm is characterized by:

(i) Large number of sellers

(ii) Homogeneous product

(iii) Free entry and exit of firms.

So far as the ‘short run’ time is concerned, no new firms can enter the industry or the existing firms exit from the industry.

Under perfect competition every firm/buyer behaves as a ‘price-taker’. To all, price is given and known. However, this price is determined in the competitive industry in the short run by short run demand and supply curves for the industry.

This price, once determined in this way, is accepted by all firms and buyers. No one has the power to influence the price. Against this backdrop of market price, a firm aims at maximizing its profit by producing a certain level of output where P = MC.

The equilibrium output of a competitive firm operating in the short run has been shown in the figure below where the revenue and cost curves have been drawn. It is to be kept in mind that a firm in the short run may enjoy abnormal profit if total revenue (TR) exceeds total cost (TC). Further, it may incur loss in the short run if TC exceeds TR. Or it may earn only normal profit if TR equals TC.

All these three possibilities have been shown in the figure below figure (a) describes supernormal profit enjoyed by a firm. Fig.(b) shows normal profit enjoyed by a firm and Fig. (c) Shows loss incurred by a firm. In all the figures, curves labeled as SAC and SMC are known as short run average cost and short-run marginal cost curves.

In the first figure the firm is in equilibrium at point E _A since at this point both the conditions for equilibrium have been satisfied.

Corres­ponding to this equilibrium point, profit- maximizing volume of output becomes OQ_A. The firm now earns revenue to the extent of OP_AE_AQ_A from the sale of output of OQ_A. And, it incurs a cost of production to the extent of OCDQ_A. Since revenue exceeds cost, the firm earns supernormal profit by the amount P_AE_ADC.

For the second figure the firm, equilibrium output is Q_B corresponding to the equilibrium point E_B. Since revenue (OP_BE_BQ_B) for OQ_B output is the same as that of its cost of production (OP_BE_BQ_B), Firm B enjoys only normal profit. Point E_B may be called break-even point since revenue equals cost.

In the last figure incurs a loss though it attains equilibrium at point E_C. In other words, a competitive firm may reach equilibrium even after incurring losses. Here, loss amounts to the area P_CE_CNM, since costs exceed revenue.

Thus, a firm in the short run may:

(i) Earn supernormal profit if

SMC = MR = AR > SAC;

(ii) Earn normal profit if

SMC = MR = AR = SAC; and

(iii) Suffer a loss if

SMC = MR = AR < SAC.