Chapter 6-1
Chapter 6-1
Chapter 6-1
Perfect Competition
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What is Firm?
A Firm is a group of people, with production tools,
located in some premises, who, with work, transform
raw materials into goods and services, and sell them
Can also be defined as a business unit which owns,
controls and manages a plant or plants, where plant
refers to the technical unit
Firm
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Then, What to Industry refers?
The Firm and Industry are two different entities but
co-related
A group of Firms producing a
homogeneous products is called
Industry and conversely we can say
a Firm is the company that operates
within the Industry to create that
product
An Industry is the name given to a certain
type of manufacturing or retailing environment
For example, the retail industry is the industry that
involves everything from clothes to computers
You can presume KFC as one firm, but all the fast
food restaurants and their suppliers would make up
the fast food Industry
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And What is the Perfect Competition?
First referring to Competition which involves one Firm
trying to take away market share from another Firm and
this process is a rivalry among the Firms
And under Perfect Competition-
There are large number of buyers and sellers of the
homogeneous product in the market
Well-informed producers and consumers about the
market
Only one price of a commodity in the whole market
Free entry (for new firms) and free exit (for old firms)
Price of a commodity is determined by the Industry and
at the determined price all the Firms can sell any
number of units of the commodity
So under perfect competition the firm is price-taker not
a price-maker
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Now the Meaning of Firm equilibrium
„Equilibrium‟ means a state of rest from which
there is no net tendency to move
So the Firm‟s Equilibrium means, “the level of output
where the firm is maximizing its profits and
therefore, has no tendency to change its output”.
In this situation either the Firm will be earning
maximum profit or incurring minimum loss i.e. it
refers to the profit maximization
In the words of Hansen, “A Firm will be in
equilibrium when it is of no advantage to increase or
decrease its output”.
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Necessary Conditions For The Firm
Equilibrium
Profit of a Firm is equal to the difference between
its total revenue (TR) and the total cost (TC) i.e.,
(Profit=TR-TC) and so for the equilibrium of the
Firm it should be maximum
Marginal cost should be equal to Marginal revenue
(MC=MR)
And when these are equal profit is maximum
Equality of MR and MC is necessary but not
sufficient, so the sufficient condition is that MC
curve should cut the MR curve from below not from
the above
No firm has an incentive to change its behavior
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Firm Equilibrium Under Perfect Competition
In Two Time Periods
As a matter of fact, the price of a good is determined
at a point where its demand is equal to supply and so
further it depends on the time taken by the demand
and supply to adjust themselves
So this time element plays a vital role in determination
of price of the goods
Acc. to Alfred Marshall - If the period is short, price
determination will be influenced more by the demand,
on the other hand, if the period is long it will be
influenced more by the supply
So the two periods we have to study-
➢ Short Period
➢ Long Period
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Short Run Firm Equilibrium
In Short run, the Firm output (supply) can be changed only
by the variable factors (like labor force through
overtime),
fixed factors (like machinery) can‟t be changed
There is not enough time for new Firms to enter the
Industry.
Further, if the demand is increased, the supply can be
increased only up to its existing production capacity
A firm in Short Run Equilibrium may face one of these
situations
➢ Super Normal Profits
➢ Normal Profits
➢ Suffer Minimum Losses
➢ Shut Down Point
For the analysis of these situations Short-run Average
Cost curve (SAC) will be introduced
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Super-Normal Profits : AR>SAC
A Firm in Equilibrium earns super normal profit, when
average revenue (price per unit) determined by the
Industry is more than its short-run average cost (SAC)
Firm equilibrium point=E, where MR (=AR) = SMC
Equilibrium output=EM
Since AR(EM)>SAC(AM)
Super Normal Profit
Firm is earning EA super
normal profit per unit of
SMC
Cost / Revenue
SAC
output P E
O M
Output 11
Normal Profits : AR=SAC
A Firm in Equilibrium earns normal profit, when average
revenue (price per unit) determined by the Industry is
equal to its short-run average cost (SAC)
Firm equilibrium point=E, where MR (=AR) = SMC
Equilibrium output=EM
At this output AR and SAC
both are equal to EM and SAC SMC
Firm is earning normal
Cost / Revenue
profit per unit of output P E
Cost / Revenue
B A
i.e. (AM-EM) Total loss
at OM level of output
=OMxAE i.e. EABP
Even if Firm discontinues P E AR=MR
the production, it will have
to bear the loss of fixed
cost which is minimum
possible loss of a Firm O
Output M
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Shut down Point : AR<SAC : AR=SAVC
The firm will shut down if it cannot cover average variable
costs i.e when AR=SAVC
A firm should continue to produce as long as price is
greater than average variable cost
Once price falls below that
point it makes sense to shut
down temporarily and save SAC
the variable costs SMC
If prices rises to OP1 SAVC
than Firm can cover some
Cost / Revenue
B A
of its Fixed costs also
So the minimum point of P1
SAVC is called Firm‟s AR1=MR 1
Shut down point
The shutdown point is P E AR=MR
the point at which the
firm will gain more by Shut-down
point
shutting down than it will M
by staying in business O Output
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Long Run Firm Equilibrium
In Long run, the Firm‟s output (supply) can be changed
by both the variable factors and fixed factors i.e. all
factors become variable
There is enough time for new Firms to enter the
Industry
Further, if the demand is increased, the supply can be
increased or decreased according to the demand
Summarizing, in long run a Firm can make all sorts of
changes
For Long run equilibrium, long run marginal cost (LMC)
is equal to MR and LMC curve cut the MR curve from
below
In case of long run equilibrium, all the firms will earn
only normal profits
even if there are other situations of short run they
will sustain only few a times
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Contd..
Take the case when the Firm earn super-normal profit-
➢ Then the existing Firm will increase their production
and new Firm will enter the Industry
➢ Consequently, the total supply will increase and price
fall down and further results in normal profit for the
firm
On the contrary, if the firm is incurring losses
➢ Then some Firm will leave the Industry which will
reduce the total supply
➢ And due to decrease in supply, price will rise and once
again Firm will begin to earn normal profit
The normal profit of a firm is also termed as zero
economic profit as this is included in the cost of
production not in the economic profit
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