Equilibrium of Firm
Equilibrium of firms means a determination of the price of any commodity. In other words, the equilibrium of a firm is that condition in which at the point of production, the profit of the firm is at the maximum.
The equilibrium of the firm may be analyzed by following two methods.
- Total revenue and total cost approach
- Marginal Revenue and Marginal Cost Approach
Total Revenue and Total cost approach:-
In this approach following 2 conditions are essential to get equilibrium:-
- Distance between TR and TC should be maximum. It will be possible, only when the rate of variation in TR and TC is the same.
- At the equilibrium production level, TR should be more or equal to the TC
The above diagram shows the TR curve of the Firm, which goes on rising equal to the level of production at 45 Degree. It means that the firm is not required to reduce the price for additional sales. In the beginning, the TC curve is above the TR curve and at OQ3. The quantity of production, TC curve is situated at the maximum distance from TR curve and hence the loss of the firm is maximum at this level of production.
At E1 point TR=TC, which is the break-even point, and the company incurs neither loss nor profit. At E2 point, OQ2 is the production quantity. Between these two points, E point is located, which shows that at this point TR and TC have the Maximum distance, which is equal to EC, which is the quantity of highest profit of the firm. In this state of equilibrium, OQ is the determined quantity of production. Hence, no change is expected in it, because production other than this level will reduce the highest profit of the firm.
Marginal Revenue and Marginal Cost approach
In this approach following two conditions are essential to get the equilibrium point.
- The equilibrium of the firm will be at that point, where the MC of the firm is equal to its MR (MC=MR).
- MC curve MR curve at the equilibrium point, from below.
In the above diagram E is the equilibrium, where MC=MR, at the OQ production. In perfect competition, AR will be equal to MR as a parallel line to OX axis
Equilibrium of firm in the short period
- The situation of abnormal profit:- A firm is in equilibrium when it makes so much production that MC=MR or MC curve cuts MR line from below. A firm gains abnormal profits in the situation of equilibrium when AR determined by the industry is higher than AC of the firm, AR>AC. The situation of equilibrium of firm is explained with the help of the following diagram.
In the above diagram E is the equilibrium point. (MR=MC) and the quantity of production is OQ. The average cost of the firm is less than the average revenue. (AR>AC). Hence, the firm is getting abnormal profit which is equal to the PEBC area.
- The situation of Normal Profit:- If the market price is only this much that the AC of the firm and AR are equal, then the firm will gain only normal profit.
In the above diagram, PL is the price line of the firm, i.e., laying line AR=MR. At point E, the firm is in equilibrium, where MR=SMC=SAC=AR, which shows that the firm is getting normal profit or zero profit by producing OQ quantity of production at OP price (Selling price).
- The situation of Loss:- In several solutions, is also possible the prevailing market price may be even then the cost of the firm, i.e., the AR curve (line) may be below even average and marginal curves. In such a situation, the firm will have to bear the loss.
In the above diagram E is the equilibrium point where MR=MC at price OP. The AC is greater than the AR (AC>AR). Hence, the firm has abnormal loss which is equal to the PEBA area.