Equilibrium of a firm in perfect competition refers to where a firm maximizes profits by changing the output levels in reaction to the changing market conditions. Under perfect competition, several firms sell the same good, and one firm cannot dictate the prices set in the market. Equilibrium prices and quantities are determined through supply equals demand in a particular market. A firm in perfect competition is a price-taker, accepting the market price as a given. The equilibrium for the firm is when its marginal cost (MC) equals the market price (P), and the firm would be operating at an optimum level of production, either short run or long run.
Equilibrium of Firm and Industry Under Perfect Competition
The equilibrium of the firm and industry under perfect competition occurs when the total quantity supplied by all firms in the market equals the total quantity demanded by consumers at a price accepted by all firms. In this state, firms are producing at the most efficient level, and no firm has any incentive to enter or leave the market.
In the case of perfect competition, it is the point where the market demand curve intersects the market supply curve that establishes the industry equilibrium. The market supply curve is derived from individual firms’ supply curves. Each firm, under conditions of perfect competition, will produce at a point at which its marginal cost, MC, curve intersects the market price. The point where the industry’s demand and supply curves intersect is the market equilibrium price and quantity. At such a price, firms attain normal profits, meaning neither making economic profits nor suffering from economic losses.
Two factors determine the equilibrium price and output of a firm in perfect competition:
- Marginal Cost (MC): The additional cost incurred by producing one more unit of output.
- Market Price (P): The price that firms accept as given in the market.
The firms produce in the industry equilibrium at the most efficient scale, where MC=MR. This point is also that at which firms in the industry collectively produce the total amount of goods demanded by consumers at that price. For the individual firm, as a price taker, producing at this level maximizes profit or minimizes loss.
Short Run Equilibrium of a Firm Under Perfect Competition
In the short run, a firm under perfect competition can make normal profits, economic profits, or suffer losses. Short run equilibrium is that state at which the firm attains maximum profit or minimizes loss by changing the quantity of output according to market price. The short-run equilibrium differs from the long-run equilibrium because it has no choice but to maintain the fixed factors of production in the short run.
Conditions for Short Run Equilibrium
In the short run, the firm under perfect competition reaches equilibrium when the following conditions hold:
- Marginal Cost (MC) = Price (P): The firm will adjust its output so that its marginal cost of producing one more unit is equal to the market price. Thus, the firm will neither overproduce nor underproduce.
- Maximization of Profit: The profit of the firm is maximized when marginal revenue equals marginal cost. The marginal revenue is equal to the price in perfect competition since the firm is a price taker.
- Minimization of Losses: If the firm is experiencing losses, it will operate in the short run provided that its total revenue covers its variable costs. The firm will close down if the price is below the average variable cost (AVC), meaning that it cannot even recover its variable costs.
Profit and Loss in the Short Run
- Profit Scenario: The firm earns economic profits when it can produce at a level where price > Average Total Cost or ATC. In the long run, it will eventually attract new entrants into the market, which will drive the price downwards, leading to normal profit returns.
- Loss Scenario: If the price is above the Average Total Cost but below the Average Variable Cost, then the firm makes losses but continues running in the short run. It will shut down when the price drops below AVC, which means that it cannot recover variable costs at that price level.
- Normal Profit Scenario: If Price = ATC, the firm is earning normal profits. In this case, total revenue equals total costs, and the firm is producing at the most efficient level.
In the short run, firms under perfect competition respond to the market price and set their output such that MC = P. If firms make economic profits, new firms enter the market, increasing supply and decreasing the market price. If firms incur losses, some firms will exit, decreasing supply and increasing the market price. However, the firm is still bound by its fixed inputs in the short run, so its adjustment ability is not comparable to that of the long run.
Equilibrium of Firm in Long Run Under Perfect Competition
In the long run, the firm operating in perfect competition attains a more stable and efficient equilibrium than in the short run. This is so since, in the long run, firms can freely vary all their inputs. The firms can enter or exit freely from the market, a condition where firms earn only normal profits. In the long run, firms adjust their productive capacity up to the level where the market price equals their minimum point of average Total Cost or ATC.
Key Features of Long-Run Equilibrium
- Entry and Exit of Firms: In the long run, firms can enter or exit the market freely. If firms are earning economic profits in the short run, new firms will enter the market to increase supply and reduce price. If firms are experiencing losses, some firms will exit, decreasing supply and increasing prices.
- Normal Profit: Under perfect competition, in the long run, a firm earns normal profit only. It occurs when price equals ATC and total revenue is equal to total cost with both explicit and implicit cost.
- Efficiency: The long-run equilibrium under perfect competition is both allocatively efficient and productively efficient. Allocative efficiency refers to the allocation of resources such that the marginal benefit to consumers equals the marginal cost of production.
Long-Run Adjustment Process
The long-run adjustment process occurs as follows:
- Economic Profits: When firms earn economic profits in the short run, new firms will enter the market, and the supply of goods increases, thereby lowering the price.
- Economic Losses: When firms are incurring losses, some firms will leave the market, and the supply of goods decreases, thereby raising the price.
- To normal profit: The market price stabilizes at a level where firms are earning normal profits as the number of firms in the market adjusts. This would occur at the level where the price equals the minimum of the average total cost curve.
The equilibrium price and output in the long run in a perfectly competitive market are determined at the intersection of the industry supply curve with the market demand curve. In a perfectly competitive market, firms produce at the most efficient level of output, and no firm has any incentive to either enter or leave the market as all firms make normal profits.
Equilibrium of Firm Under Perfect Competition FAQs
What is the equilibrium of a firm under perfect competition?
The equilibrium of a firm under perfect competition occurs when the firm adjusts its output to the market price such that its marginal cost equals the price (MC = P). At this point, the firm maximizes its profit or minimizes its loss.
How does the equilibrium of the firm under perfect competition differ in the short run and long run?
In the short run, firms may earn economic profits or incur losses, but they adjust their output to where MC = P. In the long run, firms enter or exit the market based on profitability, leading to normal profits for all firms, where Price = ATC.
What happens if a firm under perfect competition is making economic profits in the short run?
If a firm is making economic profits in the short run, new firms are likely to enter the market. This increases supply, which leads to a decrease in the price, and firms will eventually return to earning normal profits in the long run.
What is the long-run equilibrium in a perfectly competitive market?
The long-run equilibrium in a perfectly competitive market occurs when firms earn normal profits, where price equals the minimum of average total cost. This is achieved after adjustments in the number of firms in the market, either due to profits or losses.
How does the entry and exit of firms affect equilibrium under perfect competition?
The entry of firms increases supply, which reduces prices, leading to normal profits. The exit of firms decreases supply, which raises prices, also leading to normal profits. The process ensures that firms earn only normal profits in the long run.
