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Analysis of Market

Equilibrium of the Firm

A firm is in equilibrium when it has no desire to change (increase or decrease) its output levels. At the equilibrium point, the firm earns maximum profits. In this article, we will talk about the equilibrium of the firm along with two approaches to the producer’s equilibrium.

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Equilibrium of the Firm

Before we talk about the equilibrium of the firm, let’s take a quick look at the objectives of the firm.

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Objectives of the Firm

The primary objectives of a firm are:

  • Achieving a target rate of return
  • Stabilizing price and profit margins
  • Realizing a target market share
  • Preventing price competition
  • Maximizing sales or sales revenues

For a very long time, people believed that the sole objective of a firm is maximizing profits. After all, every business wants to earn maximum profits, right? However, over the years the belief changed. It is now believed that only in the case of a single-owner firm is profit maximization the sole objective.

In today’s times, the salary and perks of managers are related to the sales figures (not profit). Even financial institutions readily provide credit to firms with increasing sales. This has led to the realization of the target market share becoming an important objective of a firm.

equilibrium of the firm

                                                                                                                            Source: Pixabay

Producer’s Equilibrium

Producer’s equilibrium is the level of the output of a commodity which gives the maximum profit to the producer of the commodity. A firm is in equilibrium if there is no scope for either increasing the profit income or reducing its loss by changing the quality of the output. Therefore, we have

Profit (π) = Total Revenue – Total Cost = TR – TC

Hence, the output level at which the total revenue minus the total cost is maximum is the equilibrium level of the output. There are two approaches to arrive at the producer’s equilibrium:

  • Total Revenue – Total Cost (TR-TC) Approach
  • Marginal Revenue – Marginal Cost (MR-MC) Approach

     Learn the Basic concept of Revenue here

TR – TC Approach

According to this approach, the producer’s equilibrium has two conditions:

  • The difference between TR and TC is maximum
  • Even if one more unit of output is produced, then the profit falls. In other words, the marginal cost becomes higher than the marginal revenue if one more unit is produced.

equilibrium of the firm

In the figure above, the X-axis shows the levels of output and Y-axis shows total costs and total revenues. TC is the Total Cost Curve and TR is the Total Revenue Curve. Also, P is the equilibrium point where the distance between TR and TC is maximum.

Further, you can see that before the point P’ and after the point P”, TC>TR. Therefore, the producer must produce between P’P” or M’M”. At the point P, a tangent drawn to TC is parallel to TR. In other words, at point P, the slope of TC is equal to the slope of TR. This equality is not achieved at any other point.

MR – MC Approach

The MR-MC approach is derived from the TR-TC approach. The two conditions of equilibrium under the MR-MC approach are:

  • MR = MC
  • MC cuts the MR curve from below

MR = MC

If one additional unit of the output is produced, then MR is the gain and MC is the cost to the producer. As long as MR is greater than MC, it is profitable to produce more. Therefore, the firm has not achieved an equilibrium level of output where the profit is maximum. This is because the firm can increase its profits by producing more.

On the other hand, if MR is less than MC, then the benefit is less than cost. Therefore, the producer is not in equilibrium either. He can reduce the production to add to his profits. When MC = MR, the benefit is equal to cost, the producer is in equilibrium provided that MC becomes greater than MR beyond this level of output.

Therefore, for producer’s equilibrium MC = MR is a necessary condition but not sufficient.

      Understand Equilibrium in Monopoly here in detail.

MC cuts the MR curve from below

While MC = MR is necessary for equilibrium but it is not sufficient. This is because the producer might face more than one MC = MR outputs. Out of these, only that output beyond which MC becomes greater than MR is the equilibrium output.

This is because if MC is greater than MR, then producing beyond MR = MC will reduce the profits. Also, when it is no longer possible to add profits, the maximum profit level is reached.

On the other hand, if MC is less than MR beyond the MC = MR output, then the producer can add profits by producing more. Therefore, for the producer’s equilibrium, it is important that MC = MR. Also, MC should be greater than MR if more output is produced.

Solved Question on Equilibrium of the Firm

Q1. What are the two approaches to the producer’s equilibrium?

Answer: The two approaches to the producer’s equilibrium are:

  • Total Revenue – Total Cost (TR-TC) Approach – which has two conditions:
    • The difference between TR and TC is maximum
    • Even if one more unit of output is produced, then the profit falls. In other words, the marginal cost becomes higher than the marginal revenue if one more unit is produced.
  • Marginal Revenue – Marginal Cost (MR-MC) Approach – which has two conditions:
    • MR = MC
    • MC cuts the MR curve from below
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