# Price and Output Determination of Firm Under Perfect Competition, Equilibrium of Firm Under Perfect Competition

## Short run and long run Equilibrium of a Firm under Perfect Competition

In this article we are going to discuss about Price and Output Determination Under Perfect Competition. Micro Economics Notes

Introduction – Price and Output Determination under Perfect Competition

Though perfect competition is rare, almost a non-existent situation, yet we study price determination under the situation. A perfectly competitive market is one in which the number of buyers and sellers is very large, All engaged in buying and selling a homogeneous product without any artificial restriction and possessing perfect knowledge of a market at a time.

There are two parties which bargain in such a market, the buyers and the sellers. It is only when they agree,  a commodity can be bought and sold at a certain price. Thus product pricing is influenced both by buyers and sellers i.e., by demand and supply.

The demand and supply are the two forces, which move in the opposite directions. Price is determined at a point where these two forces are equal, that is known as equilibrium price. In a perfectly competitive market, market demand and market supply determine the equilibrium price.

### Equilibrium of a Firm under Perfect Competition

#### Meaning of Firm’s Equilibrium:

A firm is in equilibrium when it is satisfied with its existing amount of output. A firm in equilibrium has no tendency either to increase or decrease its output. . It needs neither expansion nor contraction. It wants to earn maximum profits.

In the words of A.W. Stonier and D.C. Hague, “A firm will be in equilibrium when it is earning maximum money profits.”

Equilibrium of the firm can be analysed in both short-run and long-run periods. A firm can earn the maximum profits in the short run or may incur the minimum loss. But in the long run, it can earn only normal profit.

#### Equilibrium of the firm can be studied by two approaches:

a) Total Revenue and Total Cost Approach.

b) Marginal Cost and Marginal Revenue Approach.

##### a) Total Revenue and Total Cost Approach:

According to this approach, profits are the difference between total revenue and total cost.

##### b) Marginal Revenue and Marginal Cost Approach:

This analysis is based on the following assumptions:

a) All firms in an industry use homogeneous factors of production.

b) Their costs are equal. Therefore, all cost curves are uniform.

c) They use homogeneous plants so that their SAC curves are equal.

d) All firms are of equal efficiency.

e) All firms sell their products at the same price determined by demand and supply of the industry so that the price of each firm is equal to AR = MR.

According to this approach, a firm is in equilibrium when two conditions are fulfilled:

a) Marginal Cost should be equal to Marginal Revenue (MC = MR)

b) MC curve cuts MR curve from below.

### Determination of Equilibrium of the Firm

Equilibrium of the firm can be analysed in both short-run and long-run periods. A firm can earn the maximum profits in the short run or may incur the minimum loss. But in the long run, it can earn only normal profit.

#### Short-run Equilibrium of the Firm

The short run is a period of time in which the firm can vary its output by changing the variable factors of production in order to earn maximum profits or to incur minimum losses. The number of firms in the industry is fixed because neither the existing firms can leave nor new firms can enter it. The firm is in equilibrium when it is earning maximum profits as the difference between its total revenue and total cost. A firm is short run equilibrium may face any of the three situations:

##### 1) Super Normal Profits (AR > AC):

A firm is in equilibrium when its marginal cost is equal to marginal revenue and marginal cost curve cuts marginal revenue from below. A firm is in equilibrium earns super normal profit, when average revenue is more than its average cost. It can also be explained with the help of following diagram: In this figure, output of the firm is shown on OX-axis and cost/revenue on OY-axis. MC is the marginal cost and AC is average cost curve. PP is the average revenue and marginal revenue curve (MR = AR). Supposing OP is the price determined by the industry. At this price, firm’s equilibrium will be at point E, where marginal cost is equal to marginal revenue and marginal cost curve cuts marginal revenue curve from below.

Equilibrium output is OM. At this output AR (price) = EM and AC = AM. Since AR (EM) > AC (AM), firm is earning EA super normal profit per unit of output.

Per Unit super normal profit = EA

Total Super-Normal Profit  = EABP

##### 2) Normal Profits (AR = AC):

Normal profits cover just the reward for entrepreneurial services and are included in the cost of production. So that, a firm in equilibrium earns normal profits when its average cost is equal to the average revenue i.e. AC = AR. In this figure, output of the firm is shown on OX-axis and cost/revenue on OY-axis. MC is the marginal cost and AC is average cost curve. PP is the average revenue and marginal revenue curve (MR = AR). Supposing OP is the price determined by the industry. At this price, firm’s equilibrium will be at point E, where marginal cost is equal to marginal revenue and marginal cost curve cuts marginal revenue curve from below. The firm earns normal profits at equilibrium output because its average cost and average revenue are equal.

Normal Profits = MC = MR = AC = AR.

##### 3) Minimum Loss (AR < AC)

A firm in equilibrium may incur minimum loss when the average cost is more than the average revenue and average revenue is equal to average variable cost. Even if, the firm discontinues its production, in the short run, it will have to bear the loss of fixed costs. Loss of fixed costs is the minimum loss of the firm. In this figure, output of the firm is shown on OX-axis and cost/revenue on OY-axis. MC is the marginal cost and AC is average cost curve. PP is the average revenue and marginal revenue curve (MR = AR). Supposing OP is the price determined by the industry. At this price, firm’s equilibrium will be at point E, where marginal cost is equal to marginal revenue and marginal cost curve cuts marginal revenue curve from below.

At equilibrium point An (AC) is more than EN (AR). In other words, average cost is more then average revenue by AE which represents per unit loss. As such firm’s total loss is AEPB.

Per Unit Loss = AE

Total Loss       = AEPB

From the above discussion, we may conclude from the above discussion that in the short-run each firm may be making either supernormal profits, or normal profits or losses depending upon the price of the product.

#### Long-run Equilibrium of the Firm

In the long-run, it is possible to make more adjustments than in the short-run. The firm can adjust its plant capacity and scale of operations to the changed circumstances. Therefore, all costs are vari­able. Firms must earn only normal profits. In case the price is above the long-run AC curve firms will be earning supernormal profits.

Attracted by them, new firms will enter the industry and supernormal profits will be competed away. If the price is below the LAC curve firms will be incurring losses. As a result, some of the firms will leave the industry so that no firm earns more than normal profits. Thus “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.

It’s Assumptions: This analysis is based on the following assumptions:

a) Firms are free to enter into or leave the industry.

b) All firms are of equal efficiency.

c) All factors are homogeneous. They can be obtained at constant and uniform prices.

d) Cost curves of firms are uniform.

e) The plants of firm: are equal having given technology.

f) All firms have perfect knowledge about price and output.

#### Determination of Long-run Equilibrium of the Firm

Given these assumptions, each firm of the industry will be in the equilibrium in 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 be equal to 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 3 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 quantity and sell it at OP price. Since we assume equal costs of all the firms of industry, all firms will be in equilibrium m the long-run. At OP price a firm will have neither a tendency to leave nor enter the industry and all firms will earn normal profit.

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