For a firm to earn optimum profits, it is important that it achieves a long run equilibrium. If all firms in an industry achieve a long run equilibrium, then the industry achieves the same too. In this article, we will try to understand the conditions governing the long run equilibrium of a firm and the industry.
Long Run Equilibrium of the Firm
In the long run, a firm achieves equilibrium when it adjusts its plant/s to produce output at the minimum point of their long-run Average Cost (AC) curve. This curve is tangential to the market price defined demand curve. In the long run, a firm just earns normal profits. If a firm earns supernormal profits in the short run, then the industry will attract new firms into it.
Eventually, this leads to a fall in prices of the goods and an increase in prices of the factors as the industry expands. These changes continue until the AC curve is tangential to the demand curve.
On the other hand, if firms make losses in the short-run, then they leave the industry in the long-run. This results in a rise in price and a drop in costs as the industry contracts. These changes continue until the remaining firms in the industry cover their total costs and normal profits.
OP is the price and the firm is making supernormal profits by working with the plant whose cost is SAC1. Therefore, the firm has an incentive to build new capacity and move along its LAC. Simultaneously, the excess profits attract new firms to the industry.
This leads to an increase in the quantity supplied, shifting the supply curve to the left and a fall in the price, until it reaches the point OP1. At OP1, the firms and the industry are in long run equilibrium.
Browse more Topics under Determination Of Prices
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- Monopolist’s Revenue Curve
- Price Discrimination
- Monopolistic Competition
- Kinked Demand Curve
Condition for Long Run Equilibrium of a Firm
For a firm to achieve long run equilibrium, the marginal cost must be equal to the price and the long run average cost. That is, LMC = LAC = P. The firm adjusts the size of its plant to produce a level of output at which the LAC is minimum. Now, we know that at equilibrium:
- Short-run marginal cost = Long-run marginal cost
- Short-run average cost = Long-run average cost
Therefore, in the long-run, we have: SMC = LMC = SAC = LAC = P = MR
Hence, at the minimum point of the LAC, the plant works at its optimal capacity and the minima of the LAC and SAC coincide. Also, the LMC cuts the LAC at the minimum point and the SMC cuts the SAC at the minimum point. Therefore, at the minimum point of the LAC, the equality mentioned above is achieved.
Long Run equilibrium of the industry
An industry attains long run equilibrium when:
- All firms are in equilibrium (i.e. they earn only normal profits)
- There is no entry or exit from the market
From the above figure, we can see that at point E1, AR = MR = LAC = LMC. Notice that E1 is the minimum point of the LAC curve. Therefore, at this point, the firm produces equilibrium output (OM) at the minimum cost. In a perfect competition, in the long run, all firms have an optimum size and charge the minimum possible price which just covers their marginal cost.
Hence, in such a scenario, the market mechanism leads to an optimal allocation of resources. The following conditions associated with the long run equilibrium of an industry highlight such optimality:
- The output is produced at the minimum possible cost.
- The selling price just covers the marginal cost. (i.e. MC = AR)
- In the long run, plants are used at full capacity. Therefore, resources are not wasted. (i,e, MC = AC)
- Firms earn only normal profits. (i.e. AC = AR)
- While the profits are normal, firms maximize their profits. (i.e. MC = MR)
Hence, in the long run, LAR = LMR = P = LMC = LAC. Also, the resources are utilized optimally.
Solved Question Long run Equilibrium
Q: In the long-run equilibrium of a competitive market, the firms earn:
- Normal profits
- Supernormal Profits
- No profits – No losses
- Firms suffer losses
Answer: In the long run, for a firm and/or an industry to survive in the market, it is necessary that profits are made. Hence, Options c and d are incorrect since they hint towards zero profits and even losses.
In a perfect competition, if firms from an industry book supernormal profits, then the industry will attract new firms into it. Eventually, this leads to a fall in prices of the goods and an increase in prices of the factors as the industry expands.
This continues until the equilibrium is reached. Hence, Option b is incorrect too. Therefore, the correct answer is Option a – Normal profits.