Equilibrium of the Firm Under Perfect Competition:
Question Answers
Question 1 : Explain how a firm in perfect competition incurs loss, in short -run equilibrium.
Answer:
- Under perfect competition, the individual firm is assumed to be facing a perfectly elastic demand for its product because any variation in output will have a negligible effect on total supply and market price.
- Under perfect competition a firm is a price taker because it has a negligible effect on total supply and market demand.
- The price given to the firm is determined in the industry by the forces of market demand and supply.
- The firms marginal revenue (MR) is equal to its average revenue (AR) at the level of market price (P) at every level of output and would coincide in the same straight line.
- The short run equilibrium of the firm is illustrated by combining the cost curve with perfectly elastic demand curve (AR curve) of the firm.
- A firm under perfect competition incurs losses only when it fulfill two conditions:
1. Under perfect competition, a firm in a short run is in equilibrium when its marginal cost is equal to its marginal revenue SMC = MR
For perfectly competitive firm MR =AR = P
Therefore, SMC = MR = P
So SMC curve cuts the MR line from the below.
2. A firm under perfect competition incurs loss, in short run when its short run average cost is more than its average revenue or price.
SAC > AR
In this case the price exceeds the average variable cost, the firm will continue to produce in the short run with the hope that in the long run, it will be able to recover the full average cost which includes the average fixed cost also.
Determination of Equilibrium quantity when the firm incurring losses
- In the given figure, SMC curve intersects MR or Price line at point E from the below. The point E is equilibrium point where SMC = MR .
- OQ is the equilibrium quantity at which profit is maximised at price P.
- At point E , SAC curve lies above the AR line, therefore the firm is incurring losses shown in shaded area BSEP in the figure.
- Price line lies above AVC curve, so the firm continue to produce despite losses.
Question 2 : Show with the help of a diagram how a perfectly competitive firm earns supernormal profit in short run equilibrium.
Answer:
- Under perfect competition, a firm is a price – taker, and the price is determined by the forces of market demand and supply.
- For a perfectly competitive firm, the demand is perfectly elastic, any variation in the production will have no effect on market price.
- The firm’s marginal revenue will be equal to it’s average revenue and so to price i.e., MR = AR = Price which coincide in a straight line.
- In order to determine the maximising output, the firm has to meet two types of conditions :
1. First rule for the profit maximisation output of the firm is that it must ensure that the short – run marginal cost (SMC) is equal to marginal revenue (MR) and the SMC curve cuts the MR curve from the below, as after this point MC will start rising above the additional revenue.
2. In the short – run, the firm will be in equilibrium when price (P) or average revenue (AR) is equal to the short – run average cost (SAC) .
When the average revenue (AR) is greater than average cost (SAC ), the firm earns supernormal profits.
determination of Equilibrium quantity when the firm is earning Super normal profits
The U – shaped SMC curve intersects AR = MR = P line at point E from the below. The point E is equilibrium point and OP is equilibrium price and OQ is Equilibrium quantity.
At point E, SAC curve lies below AR line therefore, AR > SAC at point E. This means the earns super normal profits shown by the shaded area BSEP.
Question 3 : A perfectly competitive firm can continue producing even if it is incurring losses in short – run equilibrium. Justify the given statement with the help of a diagram.
Answer:
We can justify the statement that a perfectly competitive firm continue producing even if it is incurring losses in short – run equilibrium as follows, with the help of a diagram:
Firm incurring losses in the short Run Equilibrium
The individual firm in perfect competition, faces a perfectly elastic demand for its product as there are many firms, selling the same type of product. It follows that firm’s marginal revenue will be equal to average revenue at the level of market price and the two would coincide and price will be equal to AR as well as MR i.e., AR = MR = Price.
Now on the supply side, the firm in the short run will be subject to the law of variable proportions as the fixed factor of production will be combined with the variable factor of production. The fixed factor e.g. machine will result in fixed costs which will be very high initially but the variable cost, e.g., on raw material, labour etc.,will be low as they will depend on the amount of output.
In case the firm is able to recover the average variable cost of production, it will continue producing in the short – run.
The quantity which a firm is willing to supply at a particular price (equilibrium output) is determined by the equality of SMC and MR (= AR = P) as shown above. At this output i.e. OQ in the diagram, the shaded area is showing losses in short – run equilibrium but the firm will continue production, hoping that in the long run, the fixed factor will be used fully and the economies of large scale production will enable the firm to reduce the cost of production and enjoy normal profit.
Question 4 : How does a perfect competitive firm earn supernormal profits in the short run equilibrium? Explain it with the help of a diagram.
Answer:
Perfect Competition:
Perfect competition is a market structure characterised by:
- Large number of buyers and sellers,
- Homogeneous product,
- Price of the commodity determined by the market forces of demand and supply and is given to all the sellers or the firms,
- Perfect knowledge among the sellers regarding the market structure,
- Freedom of entry and exit of firms.
The profit maximising firm will earn the super normal profit when it fulfill the given two conditions:
1. Short – run marginal cost (SMC) should be equal to marginal revenue or average revenue (MR = AR = Price ) at the point of equilibrium. SMC curve should cut the MR line from the below.
2. Average revenue (AR = MR = price) should exceed the short – run average cost (SAC ) i.e., AR > SAC .
Firm earning Super normal profits in the
short run
In the given figure:
The U – shaped SMC curve, cuts the AR line from the below, at point E, which is the point of equilibrium E.
At point E , the profit maximising conditions are fulfilled. OP is the equilibrium price given by the market and is constant. OQ is equilibrium quantity.
Total revenue = Price × Quantity
= OP × OQ
= Area OPEQ
Total cost = Average cost × Quantity
= SQ × OQ
= Area OBSQ
Supernormal profit = Total revenue – Total cost
= Area OPEQ – Area OBSE
= Area BPSE
The supernormal profit is shown by the shaded portion.
Question 5 : Explain how a perfectly competitive firm in equilibrium incur losses in short run. Show the same with the help of a diagram.
Answer:
Perfect competition is a market structure characterised by the following :
- There are large number of buyers and sellers,
- The commodity is homogeneous, i.e. , identical in all respects, shape, size, colour, brand name, etc.
- The price of the commodity is fixed by the forces of market demand and supply and is given to all the buyers and sellers and is constant.
- There is freedom of entry and exit of the firms.
A profit maximising firm is in equilibrium when it fulfills the following conditions:
1. The short run marginal cost should equal to marginal revenue i.e., SMC = MR (where MR = AR = Price ). The SMC curve should cut the MR line from the below.
2. At the equilibrium, the Short – run Average Cost will be equal to Average Revenue i.e., SAC = AR when the firm earns normal profit.
Since the firm incurs losses in the short run then the SAC will exceeds AR i.e. AR < SAC
Since the Average revenue is greater then Average variable cost (AVC) , the firm continues to produce the commodity despite losses with the hope that it will cover the variable cost in the long run.
The equilibrium situation is explained graphically as follows :
firm incurring losses in the short run
In the given figure
OP is the price given to the firm which is constant.
Average revenue is equal to marginal revenue (AR = MR) and is horizontal straight line parallel to x – axis.
MSAC is the short – run average cost curve which is U – shaped, though its minimum point is the short – run marginal cost curve which is also U shaped.
E is the equilibrium point where the firm’s profit – maximising conditions are fulfilled. Thus, the firm sells OQ amount of output at price OP.
The total revenue (TR) of the firm is given by multiplying price by quantity sold.
TR = OP × OQ = Area OPEQ
The total cost (TC) = average cost × output
= SQ × OQ = Area OBSQ
Supernormal profit (Ï€) is the difference between total revenue and total cost.
Thus, Ï€ = TR – TC
= Area OPEQ – Area OBSQ
= – Area PBSE
= loss
Thus, if the short run average cost exceeds the given price a firm under perfect competition incurs loss.
Question 6 : Is it possible to measure profits earned bya firm in the following diagram ? Explain why.
Answer :
We can measure the profits earned by a firm (in a competitive market) from the diagram.
The U shaped MC curve is marginal cost curve, which cuts the horizontal line or average revenue curve (AR = MR = P) from the below. Therefore, point E is the equilibrium point and OQ is equilibrium quantity at price OP.
Therefore, the quantity OQ is the equilibrium level of output of the firm which is sold at a given price P.
Therefore, total revenue (TR) = price × Quantity
= Area of OPEQ
We know that the area under the MC curve actually implies the total total variable cost (TVC) of the firm.
TVC = ΣMR = Area OAEQ
Since Profit = TR – TC
= TR – TVC = TFC
Therefore, Profit + TFC = TR – TVC
Or, Gross Profit = TR – TVC
Since TFC is constant at all levels of output, maximisation of gross profit also means maximisation of profit.
Gross profit = TR – TVC
= Area OPEQ – Area OAEQ
= Area of PEA.
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