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Q. No. 16a:

Explain equilibrium of a firm under perfect competition in short and long run?

Economics Notes

Answer: INTRODUCTION: Equilibrium means a situation in which two opposite forces are exactly equal. The basic aim of the firm is to get maximum profit. Firm will expand its output when higher profits are expected. PERFECT COMPETITION: The market structure in which there are large numbers of buyers and sellers and no one can effect the market activities. CONDITIONS OF PERFECT COMPETITION: Perfect competition takes place with the following condition. 1: Large Number of Buyers & Sellers: In perfect competition, there are large number of buyers and sellers. Buyers and sellers can not effect the market price. Price will be determined by the forces of demand and supply. 2: Homogeneous Product: In perfectly competitive market all units of a good are homogeneous and identical. 3: Perfect Knowledge: All buyers and sellers have perfect knowledge about price and products. 4: Perfect Mobility: Under perfect competition factors of production like labour and capital can move from one industry to another industry without any restriction. 5: Free Entry and Exit: In case of perfect competition new firms can enter in the industry and existing firms can leave the industry. This condition is applicable in long run. 6: Small Share of Sales: Due to large number of sellers, every firms has a small share of sales in the market. 7: Single Price: Under perfect competition there is single price in the whole market. EQUILIBRIUM OF A FIRM: Firm equilibrium means the determination of output where profits are maximized. If firm has to face losses, they must be minimized. CONDITION OF EQUILIBRIUM OF A FIRM: There are two conditions of equilibrium of a firm. a) Necessary Condition: MC = MR b) Sufficient Condition: MC must cut MR from below.

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Economics Notes
y-axis

AR P MR MC P 0

AR=MR

Q1 Q4

Q2 Output

Q3

x-axis

Explanation: In the above diagram level of output is measured along x-axis while AR, MR, MC and P are taken on y-axis. Firm is not in equilibrium situation at point A. because at this point necessary condition (MC=MR) is fulfilled while sufficient condition is not valid. Point B & C are also not equilibrium points because both points does not fulfill the two equilibrium conditions. Firm is in equilibrium situation at point E where MC and MR are equal and MC is also cutting MR from below. Therefore OP will be the equilibrium price and OQ 4 is the equilibrium quantity. SHORT RUN POSSIBILITIES: Short Run: Short run is a time period in which a firm can only change its variable factors of production. Under perfect competition there are five possibilities of a firm in short run. 1: Abnormal Profit 2: Normal Profit 3: Normal Profit 4: Shutdown Point. 5: Close Down 1: ABNORMAL PROFIT/ SUPER NORMAL PROFIT: Firm will earn abnormal profit if TR>TC. This can be explain with the help of diagram. Diagram:
C O S T & R E V E N U E
y-axis SMC

P B

SAC AR=MR A SAVC

PROFIT

Output

x-axis

The firm is in equilibrium at point E. OQ is the equilibrium quantity while OP is the equilibrium price here
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AR AC AR TR TR TR TC TC TC = = > > = = = = = = = =

Economics Notes
EP AB AC TC (AR) (Output) (EP)(OQ) (AC) (Output) (AB)(OQ) OQAB TR-TC IQEO OQAB EPAB

AS

Profit

2: NORMAL PROFIT: Firmwill earn nomal profit if TR=TC. This can be explain with the help of diagram. Diagram:
y-axis SMC SAC SAVC

Cost &
P E AR=MR

Revenues Curves

Output

x-axis

AS

AR AC AR TR

= = = =

EP EP AC TC

As

TR TR TR TC TC TC TR

= = = = = = =

(AR) (Output) (EP) (OQ) OQEP (AC) (Output) (EP) (OQ) OQEP TC = OQEP

There fore firm is earning normal profit.

3: NORMAL LOSS: Firm will face loss if TR<TC. This situation can be explain with the help of diagram. Diagram:

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Economics Notes
y-axis SMC SAC Cost & Revenue Curves T SAVC AR=MR E

G P

LOSS

x-axis

Here

AC AC TC TR

Profit:

= > > = = TR = = = Loss =

TG AR AR TR (AR) (Output) (EQ) (OQ) OQEP = TR TC OQEP OQTG TGEP

= TC

EP = = = (AC) (Output) (TG) (OQ) OQTG

Losses of the firm are TGEP. Btu firm will continue its production because fir is covering all of it ARC as well as a part of AFC. 4: SHUT DOWN: Shut down point is situation where is covering only its variable cost. This can be explain with the help of diagram. Diagram
yaxis SMC SAC Cost & Revenue Curves G SAVC AR=MR E

H P

LOSS

xaxis

The loss of the firm is GHPE. The firm is on shutdown point. The amount of loss remains the same, whether it operates or not. However, if price falls further, the firm must classes down. Therefore it is better to shutdown and wait for some good time. 5: CLOSE DOWN:
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Economics Notes

Close down is a situation where a firm has to close his business activity due to heavy losses. This can be explain with the help of diagram. Diagram:
yaxis SMC SAC G Cost & Revenue Curves P T SAVC

LOSS

AFC{ F AVC{ E AR=MR

xaxis

As equilibrium required that either profits be maximized or losses be minimized. Here firm is facing two types of losses (i) AFC = FT (ii) AVC = EF If firm closes down it will face a single loss equal to FT. therefore it is better for firm to close down. Long Run: Long run is a time period in which a firm can change its variable factors as well as fixed factors. In long run number of films in the industry can change. If a firm is earning super normal profit, new firms will join the industry. In such situation AR curve shits downwards, supernormal profit converts into normal profit. In case of losses, some existing firm leave the industry, AR shifts upward. In this situation losses will convert into normal profit. It concludes that firm will earn only normal profit in long run under perfect competition. This can be explain with the help of diagram. LONG RUN EQUILIBRIUM:

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DIAGRAM:

Economics Notes

y-axis LMC LAC AR = MR AR = MR AR = MR

P P P E E

Cost & Revenue Curves

x-axis Output

In the diagram output is measured along (x-axis) while cost and revenue curves are taken on y-axis. Firm is in equilibrium situation at Point E where (i) LMC = MR (ii) LMC is cutting MR from below. At point E firm is earning supernormal profit new firms enter into the industry price falls and AR shifts from AR to AR. At point E firm is facing loss due to loss some firm exist from industry. As a result price level increases and AR curve move upward from AR to AR. Here LAC = PF TC = (LAC) (Output) TC = (EP) (OQ) TC = OQEP TR = (AR) (Output) TR = (EP) (OQ) TR = OQEP Here
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TR = TC = OQEP

Economics Notes

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