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Analysis of Market

Equilibrium under Perfect Competition – II

Under Perfect Competition, we know that a firm is unable to affect the price of a product even if it modifies the quantity of its output. Also, in this market structure, the input and cost conditions are given. Therefore, a firm can change the quantity of the output of a product without affecting its price. The cost and revenue conditions of a firm determine its equilibrium state (maximum profits). In this article, we will talk about a firm’s long-run equilibrium under Perfect Competition.

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Equilibrium under Perfect Competition – II

A competitive firm is in equilibrium when it earns maximum profits. This invariably depends on the cost and revenue conditions of the firm. Further, the cost and revenue conditions vary on the short and long run. Therefore, a competitive firm has four equilibrium states based on its period of operation. These are:

  1. Short-run equilibrium of a competitive firm
  2. Long-run equilibrium of a competitive firm
  3. Short-run equilibrium of a competitive industry
  4. Long-run equilibrium of a competitive industry

Today, we will talk about a firm’s long-run equilibrium under Perfect Competition.

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A firm’s Long-run equilibrium under Perfect Competition

Long-term is the period in which the firm can vary all of its inputs. There are no fixed costs and therefore, the AFC or Average Fixed Cost curve vanishes. Also, the Average Cost (AC) curve represents the Average Total Cost (ATC) curve. Further, since the firm can vary all its inputs, it can close own and leave the industry.

We know that in the long-run, the AC curve which is formed by its short-run AC curves is also U-shaped. This means that up to a certain limit, the firm experiences increasing returns and the AC curve slopes downwards.

A phase of constant returns follows in which the AC curve neither rises nor falls. Subsequently, diminishing returns to scale phase starts in which the AC curve slopes upwards.

In the long-run, new firms can also enter the industry. This is the free entry and exit feature which has two implications:

  1. There is no compulsion on the firm to operate under losses and it can leave the industry.
  2. No firm can earn super-normal profits. This is because when a firm earns super-normal profits, it attracts new firms to the industry. This leads to an increase in the supply which results in lowering the prices and normalizing of profits.

long-run equilibrium under perfect competition

The figure above describes the determination of long-run equilibrium under perfect competition. As you can see, the output is measured along the X-axis and the costs along the Y-axis. Also, the firm is a price-taker.

Further, its AR curve runs parallel to the X-axis and the MR curve coincides with it.

In order to determine the equilibrium of the firm, we will consider three alternative prices that the firm receives from the industry:

Price #1

The price in the market is below the optimum cost of the firm (OP0). From this cost, we get a corresponding average revenue of AR0 and Marginal Revenue of MR0. As you can see in the figure, MR0 cuts the LMC curve at two points – E and E0.

However, none of these points is the long-run equilibrium of the firm. At point ‘E’, the LMC curve cuts the MR0 curve from above while at point E0, it cuts the curve from below. But, since AR0 < LAC, the firm incurs losses.

Price #2

The price of the firm’s product is more than the optimum cost or the least possible average cost of the firm. In such cases, the firm is not in a state of stable equilibrium. If this price is OP2 with the average revenue curve AR2 and the marginal revenue curve MR2, then we can see that

  • The LMC curve intersects the MR2 curve from below at point E2
  • AR2 > LAC

This means that the firm is enjoying super-normal profits. However, this attracts new firms to the industry which increases the supply and the price falls until no firm can earn super-normal profits.

Price #3

The price of the firm’s product is equal to its optimum cost of production. If this price is OP1 with the average revenue curve AR1 and the marginal revenue curve MR1, then we can see that

  • The MR1 curve cuts the LMC curve from below at the lowest point E1
  • AR1 = LAC

Therefore, the firm neither incurs a loss nor earn a super-normal profit. Therefore, there is no incentive for the existing firms to leave the market or new ones to join it. Also, the corresponding equilibrium output is OM1.

Hence, we can note that in long-run equilibrium, the firm produces an optimum output at the lowest possible average cost. Therefore, the firm operates under constant returns to scale. Also, we have

  • MC = AC
  • MC = MR
  • AC = AR

Therefore, we have AC = AR = MC = MR.

Solved Question on Perfect Competition

Q1. What are the four equilibrium states of a competitive firm?

Answer: The four equilibrium states are:

  1. Short-Run equilibrium of a Competitive Firm
  2. Long-Run equilibrium of a Competitive Firm
  3. Short-Run equilibrium of a Competitive Industry
  4. Long-Run equilibrium of a Competitive Industry

Q4. What is the long-run equilibrium of a competitive firm?

Answer: In long-run equilibrium, a firm produces an optimum output at the lowest possible average costs. Also, AR = AC = MC = MR.

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