27

EQUILIBRIUMOF A
3 FIRM AND INDUSTRY
IN PERFECT
COMPETITION

3.1 Equilibrium of a Firm

3.2 Short-run Equilibrium of a Firm
3.3 Short-run Equilibrium Under Differential Cost
3.4 Long-run Equilibrium of a Firm
3.5 Equilibrium of Firm and Industry
3.6 Long-run Equilibrium Under Differential Cost

3.1 EQUILIBRIUM OF A FIRM

A firm is business unit which transforms factor inputs into value

a

added goods and/or services. It is a basic

unit. The producing or supplying
legal forms of firm consists of (a) sole proprietorship
(D) partnership and
(c) a joint stock company.
r m is in equilibrium when it produces output at the point where
M R and MC is increasing at that point or MC is cuttng MR
frombelow.
 28 Business Economics-lI (F.Y.B.Com.: SEM.
We analyse the equilibrium ofa firm with the help of the followin
assumptions: ing
() The firm is rational i.e. it tries to maximise profit.

(ii) Perfect competition in product market.

(iii) Perfect competition in factor market. This assumption imnit.

identical cost of production to all the firms.
(iv) The firm operates under U shape cost curve.

(v) Price of the product is determined by the

and aggregate supply.
aggregate demand
(vi) The firm is a price taker.

When firm is in equilibrium, it need not

a
necessarily earn profit
Equilibrium refers to equilibrium output applying
=
MR and MC is conditions of MC
increasing. It enables a firm either to maximise
profit or minimise loss. Accordingly a firm is in
excess profit, normal
profit or with loss. equilibrium with
Fig. 3.1 explains the case of excess profit.

3.2 SHORT-RUN EQUILIBRIUM OF A FIRM

We are familiar with the
the cost
concept of short-run as discussed under
analysis. the short run there is a distinction between fixed
In
Cost and variable
cost. The firm
structure and operates within the given cost
capacity. The number of firms in the market remans
Constant. There is no
entry or exit from the market. The price s
determined in the market
by demand for and supply of industy
Output. The price thus determined is the
firm into a price taker. accepted by a firm, turningtt
Given the price, demand and cost, the rational
firm
aiming maximisation of profit produces output upto the oint
at
of p of
equilibrium i.e. MC =MR and MC is
increasing the p0
at
equilibrium.
 Eauilibrium ofa Firm and Industry in Perfect Competition
29
1. Excess Profit
1.

SMC SAC

N
AR MR

>X
Q Output
Fig. 3.1 : Excess Profit

The firm accepts the market price OP. At OP price the firmi
equilibrium at N. At point N the firm fulfils the equilibrium
conditions i.e. MC =MR and MC is increasing at that
point. By
dropping a perpendicular from N to the X-axis, we measure the
total output produced i.e. OQ.
The firm's total revenue
(TR) is worked out by multiplying output
(OQ) by price (OP).
TR =
OP OQ
x =
OQNP
otal cost is worked out by mul tiplying output by average cost which
oDtained at the point where QN line cuts average cost (AC) curve
at point R.

TC =OQ QR =OQRS
x

The
Sequilibrium position with excess profit is explained below.
Price OP Output OQ
TR
OONP TC OQRS
 Business EconomicS - II (F.Y.B.Com.: SEM-I)
30
Profit =TR-TC
OQNP- OQRS
SRNP

The firm earns excess profit SRNP

Excess profit is the profit earned by a firm over and above the normal

profit. It is also called supernormal profit.

2 Normal Profit
The second possibility is that a firm fails to earn excess profit but
earns only normal profit. In Fig. 3.2 the firm is in equilibrium at N,
with normal profit. The firm's operational position is shown in Fig
3.2

SMC SAC

AR MR

O >X
Q1 Output
Fig.3.2: Normal Profit
Price
OP AC =QN,
Output = OQ,
TC OQ,N,P
TR = 0Q,N,P
Tt TR-TC

=0Q,N,P, -OQ,N,P
Normal Profit
 s:ibheiumt of a Firm and Industry in Perfect Competition
31
AsTR
TC, there is no excess
profit.
The firm in this case earns only normal profits.

rhae Horinal profit is that amount of

profit which keeps a person
business. Opportunity COst is one
ot the
ides the normal profit to be earned by a firm.important factors that
In economic analysis
a l orofit is part and
no parcel
of the cost. When a firm covers the
total cost it earns normal Pprotit. In the short-run a business firm
total
mav not earn normal protit, but it must earn it in the
long-run. In
Figure 3.2 at OP Price lR IC, where the firm earns
only normnal
profit.

The possibility of earning normal profits in the short-run is rather

rare.It implies that the entire industry will settle-down in the short-
run itself which is highly improbable.

3 Loss or Sub-normal Profit

When the firm fails to normal profits it still continues to

earn
but incurring loss. Figure 3.3 shows the loss incurred. operate

Y
SMC SAC

P N AR,- MR2

Q2 Output
Fig. 3.3: Loss or Sub-normal Profit
32 Business Economics -

II (F.Y.B.Com.: SEM-In
If the
market price happens to be OP2 (Fig 3.3), the firm is in
equilibrium at Ng, producing OQ, output. The firm's equilibrium
position is:
TR OQN,P2
TC O0,TS
TC> TR

Loss P,N,TS
The loss is termed as sub normal profit.
FIRM OPERATING IN LOSS

The firm operates in the short-run with loss. The

important question
that does arise is, should the firm continue to function
with loss2
How much loss can it bear? The answer to this
on the nature of cost, i.e. fixed and
question depends
variable cost, in other words
unavoidable and avoidable cost. In the short-run a firm must endure
what it cannot avoid and must not suffer from
what it can avoid.
Figure 3.4 brings out the distinction between the two types of costs

SMC SAC
M SAVC

AR MR

---

AR, =

MR,

Output
Fig. 3.4
Equailibrium ofa Firmand Industry in Perfect Competition
In figure 3.4 at OP price, the firm is in equilibrium at R, producing
33
Its revenue and costs are:
00 output.
Output= OQ TC ACx 0Q-OQLT
Price = OP
TFC KJLT
TR =OQRP TVC OQJK
TR < TC but TR> TVc

The loss incurred is equal to a part of the fixed cost i.e. PRLT. It
cOvers the entire variable cost (OQJK) and also a part of the TFC ie.
KIRP. What is necessary for the firm is to cover the total variable
cost which otherwise is an avoidable cost. The fixed cost has to be
incurred even if the firm is closed, unless the firm wants to quit the
business which is not a wise decision in the short-run. The firm
continues to function since its TR is more than its TVC which enables
itto covera part of TFC.

4 Shut-Down Point
At price OP,, in
Fig. 3.4 the firm produces OQ output and earns
total revenue
just equal to total variable cost (TR= TVC). The firm is
in
equilibrium at S, where its TR (OQ, SP,) is equal to TVC (OQ
SP). S is the shut down
that any further decline in
point. It is the shut-down point in the sense
price will compel the firm to close down
s operation. In fact one could term this point as starting point since
the
production starts at this point where TR TVC. =

A firm is at shut-down point in Fig. 3.4 when

Price OP Output OQ
TR
0Q,SP TVC 0Q,SP
TR TVCc
The firm covers
COvers only total variable cost (TVC) but incurs the loss to
the
to
the exten of total fixed cost (TFC). In the short-run a firm requires
tobear the loss to the extent of total fixed cost, if necessary. Hence it
is
is
expected to
tal variable continue its operation as long as its total
revenue covers

cost (TR=
TVC).
34 Business Economics- Il (E.Y.B.Com.:
SEM.n
Figure 3.5 explains the situation where the firm requires to clos
down and wait for better times to come.

SMC SAC

SAVC

AR MR
X
Output
Fig. 3.5

Atprice OP, if the firm decides to produce its

equilibrium output
OQ its TVC= OQSN and TR=OQRP.
PRSN. The firm's total loss is PRMT
The TR TVC by the amount
<

which
is made up
PRSN of TVC and NSMT the total
fixed cost. At this
partly of
firm is not in a price (OP), the
position to cover even the variable cost. Therefore
the best advice for the firm is to
close down and wait for the
go up or the cost to decline so that it
can cover atleast the TC
price to
possibly cover the TFC too. and
A firm closes its
3.5.
operation when its TR < TVC as shown in figure

In the above (3.5) diagram,

Price OP Output = OQ
TR = OQRP
TVC OQSN
Loss in terms of
variable cost PRSN
It is advisable for
the firm to close down its
or ait for
operation
better times, that is, for
the price to increase or a decline in walt riable
cost its va
enabling to cover at least the total variable cost so that starts
it
its operation.
Epuilibrium ofaa Firm
utt of and ndustry in Perfect Competition
analysis under identical cost leads to a
. m 35
Equilnn situation where
E q u i l i b r i t

at any given time all the firms will be in a

at any 8 particular
willl be operating either with excess position i.e. all
the
firms
the profit
When the firms incur loss, again all the
or normal
profit
or
loss.
firms will have the
amount of loss.
same

e MMARY OF DIFFERENT EQUILIBRIA POSITIONS

Ti 36 explains all four positions discussed earlier.

SM SAC

SAVC

AR MR

N1
AR,MR
N
ARMR
ARMR

K
Q1 Q

Fig. 3.6: Different Equilibrium Positions

Excess
neabove diagram explains 4 different positions, that isthat (0)
is shut-
PrOTit (11) Normal profit (iii) LosS, covering variable cost,
point and (iv) Total loss thus forcing the firm to close down.
different price levels.
explain the positions of the firm at
36 Business Economics-II (E.Y.B.Com.:
SEM,
At equilibrium point N -
Excess Profit

P AR > SAC

At equilibrium point N, - Normal Profit

P AR, =SAC
At equilibrium point N,- Loss but covers Variable Cost Shut dou -

point own
P,= AR, =
SAVC

At equilibrium point Na -
Loss Firm closes down
-

P AR, <SAVC
When,
AR> SAC =TR> TC =
Excess Profit
AR SAC =
TR =
TC =
Normal Profit
AR =SAVC =TR =TVC Loss but covers total variable
=

down point cost-Shut

AR <SAvC =
TR <TVC -

Firm closes down

3.3 SHORT-RUN EQUILIBRIUM UNDER

DIFFERENTIAL COST
In
reality
the firms do not
operate with identical cost. Each f m
differs in its cost since in
reality the factor market is impenfect
Among the firms, those which are more efficient will have
loww
and the least efficient, the higher cost. Accordingly, profits
differ from firm to firm. Figure 3.7 explains that case
 uilibrium fa Firm and Industry in Perfect Competition
37
Excess Profit
Normal Profit
A B

SMCSAC SMC SAC

-AR= MR
- AR MR
X
Q Q1 X
Output Output
Loss but covers TVC Covers only TVC-
and part of FC Shut down Point
C D
SMC SAAC SMC SAC
SAVC
SAVC
M -
AR =
MR AR MR
K

0
T
Q1 X
Output Q
Fig. 3.7
Output

Figure 3.7 has four diagrams A, B, C and D. In the product market

the price is determined by the aggregate demand and supply which
IS
accepted by the firm. For a given price, the firms operate producing
equilibrium output and try to maximise profit or minimise loss. In
igure 3.7 A, the firm earns super normal protit, in B only normal
profit, in C the firm incurs loss but covers total variable cost and
aiso a
part of the fixed cost and finally in D, the firm
just covers the
Variable cost and
operates at shut-down point. From the above
lanation it is clear that at any given time firms operate with
different amount of profit or loss. Only those firms which cannot
even
COver cover the
the variable cost are compelled to close down and wait
for either the price to go up or the cost to decline.
 Business Economics - lI (E.Y.B.Com.: SEM.t
38
-1)
3.4 LONG-RUN EQUILIBRIUM OF A FIRM

the costs are variable. The f i

Long-run is a time period where all
as required. New firms mav er
can expand or contract its capacity
the market if the existing firms earn excess profit. Those firms wh
cannotcover the total cost would leave the market. Thus in the lone.
run there is entry to and exit from the market. The firms whick
ng
remain in the market will earn only normal protit. Figure 3.8 shows
the long-run equilibrium of a firm.

LMC LAC

AR MR

O Q
Output
Fig. 3.8

The long-run position of the firm is -

Output OQ TC =AC x
Q OQx QS
=
=O05S
Price = OP TR OQSP

TR= TC
The firm earns normal
profit at a technical point where
P AR =
MR =
AC =
MC.
In Figure 3.8 at oned
point S the firm is at the technical point ment
above. At this point, the firms' TR TC the

normal profit.
giving the firm o
=
Eauilibriun of a Firm and Industry in Perfect Competitiom
39
Eq
EEOUILIBRIUM OF FIRM
3.5
AND INDUSTRY

dustry is usually in equilibrium only in the long-run. New firms

Indu
attracted to the industry due to excess profit earned by the
are

icting firms. Those who incur loss leave the industry. Entry of
new firms will wipe out the excess profits. Similarly, the exit of loss
incurring firms, will enable the remaining firms to earn normal
nrofits. Thus, the firms earning normal profits alone will remain in
thelong run as shown in diagram 3.9 A & B.
Industry Firm
LMC
S
S LAC
AR MR
P
-AR MR

P2 -AR2 MR
Si D

X
Q2 Q Q1
Total Output
Output
Fig. 3.9 (A) & (B)

igure 3.9A depicts the industry where aggregate demand and

uPply determine the price. Figure 3.9B shows the equilibrium
pOsition of a firm. At OP, price in the market, the firm produces
Output and earns excess profit NLTP. Attracted by this
=

ernormal profit, more firms enter the market and supply curve
t o t h e right. The increased supply shown by SS supply curve
brings down the price to OP. At OP which is a lower price the firm
produces less and earns only normal profit and is in equilibrium at
E. Its TR (OQEP) is
equal to its TC (OQEP).
If the market price is at OP, due to excess supply in the market, the
firm is in loss with its TC
(O0 OQ, output. Its TR (OQ,MP,) is less than
Q,SN). The loss is equal to P,MSN. Since it is the long-run the
1s
which ncur
incur loss
lo quit the industry, leaving behind only
those
 Business Economics - 11 (F. Y.B.Com.:SEM-I
40
firms earning normal profit. Under the identical cost conditione
we have all the firms earning only normal profit and therefore t
ns,
e
industry is in equilibrium with normal profit.

3.6 LONG-RUN EQUILIBRIUM UNDER

DIFFERENTIAL COST

Under identical cost, a firm in the long-run, operating in a

perfectly
competitive market, is in equilibrium with normal profits at a point
where P= AR = MR = AC= MC. Since there is free entry andexit,

all the firms in the long-run will earn only normal profit. The
situation changes under differential cost. In the long-run no firm
can continue to function with loss. It must cover all the cost. However
it is not necessary that firms must earn only normal profit. Those
firms which are more efficient earn different amounts of super
normal profit and others only normal profit. Figure 3.10 explains
the two possible cases of long-run equilibrium under differential
COst.

Excess Profit Normal Profit

A B LMC LAC
LMC
LAC

AR AR
MR
S
MR

X
Q
Output Output
Fig. 3.10

gory
InF'igure 3.10 firm A earns excess profit. All firms of A cate
will earn excess profit which differ from firm to firm. The Dir
firms with Thus
normal efficiency will earn only the normal pron w h i c h

t h e long-run there are only two categories of firms thoSe

 ipuilabrium a Firm and Industry in Perfect Competition
41
are more
e effici efficient earning excess ofits and others,
only normal
profits.

Perfect competition, though more of a theoretical analysis, yet helps

us derive Certain important principles or rules which are applicable
husiness decisions. Equilibrium output, shutdown point, the role
to b u s i r

a firm and the entire industry in price determination are some of

useful concepts.
the very

A SUMMARY OF PERFECT COMPETITION

No. ofsellers Large

Nature of commodity
Homogeneous
Entry/Exist Free
Market information
Complete
Transport cost Nil
Mobility of factors
Perfect
Equilibrium output MC MR and MC is
increasing
at that point
(MC cuts MR from
below)
Demand curve of a firm Horizontal -Perfectly elastic
Price Same throughout the market
Price determined by Total demand and total supply
in the market
Firm is a
Price taker
Short-run Profit Excess or Normal
Short-run Loss Loss=Total Fixed Cost
Shut-down Point Loss= TFC i.e. TR =
TVC
Firm stops operating- When loss> TFC or
Short-run P (AR) < SVC or TR < TVC
No. of firms in the Remains the same as firms do
short-run
not enter or exit
No. of firms in the enter and exit
long-run Changes as firms
42 Business Economics II (F.Y.B.Com.:
SEM
-

Short-run supply curve ofa Equal to SMC above the SVCc

firm
Long-run supply curve of a Equal to MC above AC
firm
Profit in the short-run Excess/ Normal / Sub-normal
Maximum short-run loss Equal to TFC
Short-run avoidable cost Equal to Total Variable Cost
Short-run unavoidable cost Equal to Total Fixed Cost
Firm operates in the short-run Loss TFC TR
=
or =TVC
till the point

Under Differential Cost:

(a) The short-run profits Differs depending on the
efficiency of firm
(b) Thelong-run profits Differs based on efficiency
Loss in the long-run Firm exits the market - does

not operate with loss

Shut-down point in the
long-run
Approximate example of
perfect competition
Does not exist. Firm must cover
all the cost in the long-run
Agricultural commodities,
Stock market, Foreign
exchange market

PROBLEMS
Q.1 A firm can sell its product for petitive
20 each in a perfectly compe
range o
market. Its total cost of production for the productioni
200 units to 205 units is given below:
205
200 203 204
201 202
3720
3688
3600 3615 3635 3658

What is the profit maximizing level of production

 ofa
Firm and Industry in Perfect Competition 43
Eguilibrium
the following table.
Complete
o.2
COSTS REVENUES
Quantity Total MarginalQuantity Price Total Marginal
Produced
Cost Cost Demanded Marginal
Revenue Revenue
100 0 120
150 120
202 120
257 120
4 317 120
385 120
465 120
562 120
8 682 8 120
9 832 9 120

0 What is the profit maximizing output ? Why?

(i) What is the maximum profit ?

Q.3 Suppose the total cost for various levels of output for a
competitive firm are given in the table below:

Q TC
0 10
12
15
19
24
30
38
48
60
75

eThe market price is 8. Find MC, MR, TR and profit maximzing

Output.
 44 Business Economics- l1 (F.Y.B.Com.: SEM.
Q.4 If the industry under perfect competition faces a downwa
sloping demand curve, why does an individual firm fac
ce a
horizontal demand curve?

Q.5 Do you think the markets for agricultural commodities in Ind

are perfectly competitive? Justify your answer.

REVIEW QUESTIONS
1. Explain the short-run equilibrium of a firm with excess profit, norm
profit, loss and loss covering only TVC.
2 Explain the long run equilibrium of a firm and industry.
3. What is the significance of distinction between TFC and TVC for a
firm's short run operational decision?
4. Explain short-run equilibrium of firms with differential costs.
. Explain the conditions under which firms in the long-run earn different
amount of profit.
66. Distinguish between:
) Normal Profit and Excess Profit
i) Long run equilibrium of industry and firm
ii) Short-run and Long-run Equilibrium with Differential Cost

OBJECTIVE QUESTIONS
A. Answer the following in one sentence:
1. What is normal profit ?
What is shut-down point ?
3 What are the conditions of long-run equilibrium of firm underperfe
competition?
B. Select the correct answer from the alternatives given d rew
the answer
1. A firm's
equilibrium output is produced at a point
(a) MC MR (b) MC> MR
(c) MC < MR
2 In the long-run all cost are
(a) fixed (b) variable
(c) avoidable
 ofa Firm and Industry in Perfect Competition 45
ilibrium
EgulIn perfect competition, the actions of an individual buyer or seller will

no impact on the market price

ial
(a)
Have
on production
Have
some impact
(b)
Have a signiticant mpact on market supply
(c)
Have a significant impact on market demand
f i r m in a pertectly competitive market doubles the number of
4. sold, then total revenue will
units of output
More than triple (b) Halve
(a)
(c) Exactly double (d) Remain constant
Sellers will have little reason to charge less than the going market
price because

(a) There will be few buyers in the market

There will be few sellers in the market
(b)
have greater advantage
() Buyers will
(d) Goods sold are homogenous
A firm in perfect competition, might decide to set its price below the
6.
market price, because

(a) This would result in higher total revenue

(b) This would result in higher profits
(c) This would result in lower marginal cost
(d) None of the above is correct
Suppose a firm in a competitive market produces and sells 100 units
of output and has a marginal revenue of 8.00. What would be the
firm's total revenue if it instead produces and sold 200 units of output?
(a) 1600.00 (b)1000.00
(c) 800.00 (d) 2000.00
t a firm in
perfect competition earns 1000 in total revenue and has
narginal revenue of R 10. What is the average revenue per unit, and
how many units were sold?
(a) 75 and 50 (b) 5 and 100
(c) 710 and 50
(d) 1 0 and 100
Suppose a firm in a perfectly competitive market sells 2000 units and
earns
(a al revenue of 50000, what is marginal revenue of the firm ?
(a)50
) Less (b) R 25
0. than 25 (d) None of the data
hanges in the output of perfectly competitive firm, without any
chang in the price of the product, will change the firm's
a

(a) Total revenue

(b) Marginal revenue
e) Average revenue
All of the above are correct
(d)
 46 Business Economics - II (F.Y.B.Com:SE
11. A firm in perfect competition selling commodity X, maximizesn.
SEM
If the market price for X falls below the firm's average total co pro
still lies above average variable cost, the firm cost, b
(a) Will shut down
(b) Should raise the price
(c) Will incur losses but will continue to produce
(d) All the above
12 Which of the following statements is true about the decision ofapri
profi
maximizing firm in a competitive market when price falls belows
minimum of average variable cost ?
(a) The firm will continue to produce to meet its fixed costs
(a)
(6) The firm will immediately stop production to minimize its lose
(c) The firm will stop production as soon as it is able to pay its suri
costs
(d) The firm will continue to
produce in the short run but will ikeh
exit the market in the long run
13. A
profit-maximizing firm will shut down in the short run when
(a)
(a) Price is less than average variable cost
(b) Price is less than average total cost
(c) Average revenue is greater marginal cost
(d) Average revenue is greater than average fixed cost
14. Which of the following statements is correct
regarding a firms
decision-making?
(a) The decision to shut down and the decision to exit are
shor both
run decisions.
(b) The decision to shut down and the
decision to exit are both long
run decisions.
(c) The decision to shutdown is a
short-run decision, whereas t
decision to exit is a
long-run decision.
(d) The decision to exit is a
short-run decision, whereas the deCIs
to shutdown is a
Ans.:(1) (a), (2) (b), (3) - (a),
-
long-run decision.
(4) (c), (5) (d), (6) (), (7) (a), (8)
-

-
-
- - -

(9) (b), 10) (a), 11)

- (c), (12) (b), (13) (a), (14) (e)
-

-
- -

C. Match the
following statements :
Column A Column B
1. Excess profit in the
2. Shut-down point
long-run (a) All cost are variable
(b) P=AR = MR = AC M
3. Short-run loss
(c) Differs under differentia
In the long-run
Cost
 hriumm ofa Firm andl dustry in Perfect Competition
47
Profit in the long-run (d) Equal to TFC
(e) AR=SAVC
() AR> AC
- (), 2)- , 3)- (d), (4) - (a), (5) - ()
Ans.:

D. State with reasons whether the following statements are true or

false:

In short-run,
's
a firm's total revenue must be
total variable cost.
equal or more than the
Girm need not cover its fixed cost in the short-run.
in the long-run, firms may enter or leave the industry.

Ans
True; For Reasons : Refer Section 3.2 (4).
2 True; For Reasons: Refer Section 3.2 (3).
3. True; For Reasons: Refer Section 3.3.
FA vendor at the roadside, selling eatables, is one among the large
number of sellers, selling the same items. He is incurring a loss in his
business. He is unsure about continuing his business.

If vou have to advise this vendor, what

aspects of his business would
you take into consideration ? After
analysing all the factors, what
would be your advise?