PROJECT REPORT

ON

EQUILIBRIUM OF FIRM & INDUSTRY

UNDER
PERFECT COMPETITON

SUBMITTED BY: SAKSHAM PURI

COURSE: B.COM-L.L.B.(5 year INTEGRATED)

SEMESTER: I

ROLL NO.-170

SUMITTED TO: MRS.NEERAJ

 INDEX
1.Acknowledgement

2.Introduction

3.How Perfect Competitive Firms make Output decisions

4.Shutdown Point

5.Conditions of Equilibrium of Firm and Industry

6.Short run Equilibrium of Firm and Industry

7.Long run Equilibrium of Firm and Industry

8.Conclusion

9.Bibliography
 Acknowledgement

I am highly indebted to our teacher Mrs .Neeraj for assigning us this research
project on EQUILIBRIUM OF FIRM AND INDUSTRY UNDER PERFECT
COMPETITION. I am thankful to my parents, family and friends who provided
me with valuable suggestions on this research project. I am also thankful to our
teachers who provided us guidelines on how to complete this project. This
project helped us enhance our knowledge on Equilibrium of firm and industry
under Perfect Competition.
INTRODUCTION

It is essential to know the meaning of firm and industry before

analysing the two. Firm is an organisation which produces and
supplies goods that are demanded by the people with the goal of
maximising its profits

According to R.L.Miller, “Firm is an organisation that buys and

hires resources and sells goods and services.” To Lipsey, “Firm is
the unit that employs factors of production to produce commodities
that it sells to other firms, to households, or to the government.”1

Industry is a group of firms producing homogeneous products in a

market. According to Lipsey, “Industry is a group of firms that
sells a well-defined product or closely related set of
products.” For example, Raymond, Maffatlal, Arvind, etc., are
cloth manufacturing firms, whereas a group of such firms is called
the textile industry.2

Most businesses face two realities: no one is required to buy their

products, and even customers who might want those products may
buy from other businesses instead. Firms that operate in perfectly
competitive markets face this reality. Industries differ from one
another in terms of how many sellers there are in a specific market,
how easy or difficult it is for a new firm to enter, and the type of

1
Carbaugh, 2000

2
Chiller, 1991
products that they sell. Economists refer to this as an industry's
market structure.

Perfect Competition and Why It Matters

Firms are in perfect competition when the following conditions

occur:
(1) many firms produce identical products;
(2) many buyers are available to buy the product, and many sellers
are available to sell the product;
(3) sellers and buyers have all relevant information to make
rational decisions about the product that they are buying and
selling; and
(4) firms can enter and leave the market without any restrictions—
in other words, there is free entry and exit into and out of the
market.3
A perfectly competitive firm is known as a price taker, because the
pressure of competing firms forces it to accept the prevailing
equilibrium price in the market. If a firm in a perfectly competitive
market raises the price of its product by so much as a penny, it will
lose all of its sales to competitors. 4When a wheat grower, as we
discussed in the Bring It Home feature, wants to know the going
price of wheat, he or she has to check on the computer or listen to
the radio. Supply and demand in the entire market solely determine
the market price, not the individual farmer. A perfectly competitive
firm must be a very small player in the overall market, so that it can
increase or decrease output without noticeably affecting the overall
quantity supplied and price in the market. A perfectly competitive
market is a hypothetical extreme; however, producers in a number
of industries do face many competitor firms selling highly similar
goods, in which case they must often act as price takers. Economists
often use agricultural markets as an example. The same crops that

3
Lipsey, 1975. pp. 285–59.

4
Mansfield, 1989
different farmers grow are largely interchangeable. 5According to
the United States Department of Agriculture monthly reports, in
2015, U.S. corn farmers received an average price of $6.00 per
bushel. A corn farmer who attempted to sell at $7.00 per bushel,
would not have found any buyers. A perfectly competitive firm will
not sell below the equilibrium price either. Why should they when
they can sell all they want at the higher price6

How Perfectly Competitive Firms Make Output

Decisions
A perfectly competitive firm has only one major decision to make—namely,
what quantity to produce. To understand this, consider a different way of
writing out the basic definition of profit:

Profit=Total revenue−Total cost

= (Price) (Quantity produced) − (Average cost) (Quantity produced)

Since a perfectly competitive firm must accept the price for its output as
determined by the product’s market demand and supply, it cannot choose the
price it charges. This is already determined in the profit equation, and so the
perfectly competitive firm can sell any number of units at exactly the same
price. It implies that the firm faces a perfectly elastic demand curve for its
product: buyers are willing to buy any number of units of output from the firm
at the market price. When the perfectly competitive firm chooses what
quantity to produce, then this quantity—along with the prices prevailing in the
market for output and inputs—will determine the firm’s total revenue, total
costs, and ultimately, level of profits.7

Determining the Highest Profit by Comparing Total Revenue and Total Cost

A perfectly competitive firm can sell as large a quantity as it wishes, as long as

it accepts the prevailing market price. The formula above shows that total
revenue depends on the quantity sold and the price charged. If the firm sells a

5
Bork, Robert H. (1993). The Antitrust Paradox (second edition). New York: Free Press. ISBN 0-02-
904456-1.

6
LeRoy Miller, 1982.

7
Lipsey, R. G.; Lancaster, Kelvin (1956). "The General Theory of Second Best". Review of Economic
Studies. 24 (1): 11–32. doi:10.2307/2296233. JSTOR 2296233.
higher quantity of output, then total revenue will increase. If the market price
of the product increases, then total revenue also increases whatever the
quantity of output sold. As an example of how a perfectly competitive firm
decides what quantity to produce, consider the case of a small farmer who
produces raspberries and sells them frozen for $4 per pack. Sales of one pack
of raspberries will bring in $4, two packs will be $8, three packs will be $12,
and so on. If, for example, the price of frozen raspberries doubles to $8 per
pack, then sales of one pack of raspberries will be $8, two packs will be $16,
three packs will be $24, and so on.8

Table 1 graphically shows total revenue and total costs for the raspberry farm,
also appear in Figure2. The horizontal axis shows the quantity of frozen
raspberries produced in packs. The vertical axis shows both total revenue and
total costs, measured in dollars. The total cost curve intersects with the vertical
axis at a value that shows the level of fixed costs, and then slopes upward.

Figure 2 Total Cost and Total Revenue at the Raspberry Farm Total revenue
for a perfectly competitive firm is a straight line sloping up. The slope is equal
to the price of the good. Total cost also slopes up, but with some curvature. At
higher levels of output, total cost begins to slope upward more steeply
because of diminishing marginal returns. The maximum profit will occur at the
quantity where the difference between total revenue and total cost is largest.9
8
"Microeconomics – Zero Profit Equilibrium". Retrieved 2014-12-05.

9
Gerard Debreu, Theory of Value: An Axiomatic Analysis of Economic Equilibrium, Yale University Press,
New Haven CT (September 10, 1972). ISBN 0-300-01559-3
 Quantity Total Cost Total Revenue
(Q) (TC) (TR)
0 $62 $0
10 $90 $40
20 $110 $80
30 $126 $120
40 $138 $160
50 $150 $200
60 $165 $240
70 $190 $280
80 $230 $320
90 $296 $360
100 $400 $400
110 $550 $440
120 $715 $480
Table 1 Total Cost and Total Revenue at the Raspberry Farm10

Based on its total revenue and total cost curves, a perfectly competitive firm
like the raspberry farm can calculate the quantity of output that will provide
the highest level of profit. At any given quantity, total revenue minus total cost
will equal profit. One way to determine the most profitable quantity to
produce is to see at what quantity total revenue exceeds total cost by the
largest amount. Figure 2 shows total revenue, total cost and profit using the
data from Table 1. The vertical gap between total revenue and total cost is
profit, for example, at Q = 60, TR = 240 and TC = 165. The difference is 75,
which is the height of the profit curve at that output level. The firm doesn’t
make a profit at every level of output. In this example, total costs will exceed
total revenues at output levels from 0 to approximately 30, and so over this
range of output, the firm will be making losses. At output levels from 40 to
100, total revenues exceed total costs, so the firm is earning profits. However,
at any output greater than 100, total costs again exceed total revenues and the
firm is making increasing losses. Total profits appear in the final column
of Table 1. Maximum profit occurs at an output between 70 and 80, when
profit equals $90.11

10
Samuelson, W & Marks, S (2003) p. 227.

11
Landsburg, S (2002) p. 193

Landsburg, S (2002) p. 194

A higher price would mean that total revenue would be higher for every
quantity sold. A lower price would mean that total revenue would be lower for
every quantity sold. What happens if the price drops low enough so that the
total revenue line is completely below the total cost curve; that is, at every
level of output, total costs are higher than total revenues? In this instance, the
best the firm can do is to suffer losses. However, a profit-maximizing firm will
prefer the quantity of output where total revenues come closest to total costs
and thus where the losses are smallest.12

Later we will see that sometimes it will make sense for the firm to close, rather
than stay in operation producing output.

Comparing Marginal Revenue and Marginal Cost

Firms often do not have the necessary data they need to draw a complete total
cost curve for all levels of production. They cannot be sure of what total costs
would look like if they, say, doubled production or cut production in half,
because they have not tried it. Instead, firms experiment. They produce a
slightly greater or lower quantity and observe how it affects profits.

Figure 3 presents the marginal revenue and marginal cost curves based on the
total revenue and total cost in Table 1. The marginal revenue curve shows the
additional revenue gained from selling one more unit. As mentioned before, a
firm in perfect competition faces a perfectly elastic demand curve for its
product—that is, the firm’s demand curve is a horizontal line drawn at the
market price level. This also means that the firm’s marginal revenue curve is
the same as the firm’s demand curve: Every time a consumer demands one
more unit, the firm sells one more unit and revenue increases by exactly the
same amount equal to the market price. In this example, every time the firm
sells a pack of frozen raspberries, the firm’s revenue increases by $413.Table2

12
Perloff, J. (2009) p. 231.

13
Henderson, James M., and Richard E. Quandt, "Micro Economic Theory, A Mathematical Approach. 3rd
Edition", New York: McGraw-Hill Book Company, 1980. Glenview, Illinois: Scott, Foresmand and Company,
1988.
shows an example of this. This condition only holds for price taking firms in
perfect competition where:

Marginal revenue = price

The formula for marginal revenue is:

Marginal revenue = change in total revenue/change in quantity

Price Quantity Marginal Revenue
$4 1 -
$4 2 $4
$4 3 $4
$4 4 $4
Table 214

Notice that marginal revenue does not change as the firm produces more
output. That is because under perfect competition, the price is determined
through the interaction of supply and demand in the market and does not
change as the farmer produces more (keeping in mind that, due to the relative
small size of each firm, increasing their supply has no impact on the total
market supply where price is determined).

Since a perfectly competitive firm is a price taker, it can sell whatever quantity
it wishes at the market-determined price. We calculate marginal cost, the cost
per additional unit sold, by dividing the change in total cost by the change in
quantity. The formula for marginal cost is:

marginal cost = change in total/ cost change in quantity

Ordinarily, marginal cost changes as the firm produces a greater quantity.

In the raspberry farm example, in Figure 3, Figure 4 and Table 3, marginal cost
at first declines as production increases from 10 to 20 to 30 to 40 packs of
raspberries—which represents the area of increasing marginal returns that is
not uncommon at low levels of production. At some point, though, marginal
costs start to increase, displaying the typical pattern of diminishing marginal
returns. If the firm is producing at a quantity where MR > MC, like 40 or 50
packs of raspberries, then it can increase profit by increasing output because
the marginal revenue is exceeding the marginal cost15. If the firm is producing

14
Smith (1987) 245.
15
Bade and Parkin, pp. 353–54.
at a quantity where MC > MR, like 90 or 100 packs, then it can increase profit
by reducing output because the reductions in marginal cost will exceed the
reductions in marginal revenue. The firm’s profit-maximizing choice of output
will occur where MR = MC (or at a choice close to that point).

Figure 3 16Marginal Revenues and Marginal Costs at the Raspberry Farm:

Individual Farmer For a perfectly competitive firm, the marginal revenue (MR)
curve is a horizontal line because it is equal to the price of the good, which is
determined by the market, as Figure 4 illustrates. The marginal cost (MC) curve
is sometimes initially downward-sloping, if there is a region of increasing
marginal returns at low levels of output, but is eventually upward-sloping at
higher levels of output as diminishing marginal returns kick in.17

16
Tirole, 1988.

17
Melvin & Boyes, (2002) p. 222.
Figure 4 Marginal Revenues and Marginal Costs at the Raspberry Farm:
18
Raspberry Market The equilibrium price of raspberries is determined through
the interaction of market supply and market demand at $4.00.
Quantity Total Cost Marginal Cost Total Revenue Marginal Revenue
0 $62 - $0 $4
10 $90 $2.80 $40 $4
20 $110 $2.00 $80 $4
30 $126 $1.60 $120 $4
40 $138 $1.20 $160 $4
50 $150 $1.20 $200 $4
60 $165 $1.50 $240 $4
70 $190 $2.50 $280 $4
80 $230 $4.00 $320 $4
90 $296 $6.60 $360 $4
100 $400 $10.40 $400 $4
110 $550 $15.00 $440 $4
120 $715 $16.50 $480 $4
19
Table 3 Marginal Revenues and Marginal Costs at the Raspberry Farm

18
Samuelson, W & Marks, S (2003) p. 227.

19
Frank (2008) 351.
In this example, the marginal revenue and marginal cost curves cross at a price
of $4 and a quantity of 80 produced. If the farmer started out producing at a
level of 60, and then experimented with increasing production to 70, marginal
revenues from the increase in production would exceed marginal costs—and
so profits would rise. The farmer has an incentive to keep producing. At a level
of output of 80, marginal cost and marginal revenue are equal so profit doesn’t
change. If the farmer then experimented further with increasing production
from 80 to 90, he would find that marginal costs from the increase in
production are greater than marginal revenues, and so profits would decline.20

The profit-maximizing choice for a perfectly competitive firm will occur at the
level of output where marginal revenue is equal to marginal cost—that is,

20
"United States of America, Plaintiff, v. Microsoft Corporation, Defendant", Final Judgement, Civil Action
No. 98-1232, November 12, 2002.
 21
where MR = MC. This occurs at Q = 80 in the figure

Profits and Losses with the Average Cost Curve

Does maximizing profit (producing where MR = MC) imply an actual economic

profit? The answer depends on the relationship between price and average
total cost, which is the average profit or profit margin. If the market price is
higher than the firm's average cost of production for that quantity produced,
then the profit margin is positive and the firm will earn profits. Conversely, if
the market price is lower than the average cost of production, the profit
margin is negative and the firm will suffer losses. You might think that, in this
situation, the firm may want to shut down immediately. Remember, however,
that the firm has already paid for fixed costs, such as equipment, so it may
continue to produce for a while and incur a loss22. Table 3 continues the
21
Png, I: 1999. p. 102

22
Lipsey, 1975. pp. 285–59.
raspberry farm example. Figure 5 illustrates the three possible scenarios: (a)
where price intersects marginal cost at a level above the average cost curve,
(b) where price intersects marginal cost at a level equal to the average cost
curve, and (c) where price intersects marginal cost at a level below the average
cost curve.

Figure 5 Price and Average Cost at the Raspberry Farm In (a), price intersects
marginal cost above the average cost curve. Since price is greater than average
cost, the firm is making a profit. In (b), price intersects marginal cost at the
minimum point of the average cost curve. Since price is equal to average cost,
the firm is breaking even. In (c), price intersects marginal cost below the
average cost curve. Since price is less than average cost, the firm is making a
loss.23

First consider a situation where the price is equal to $5 for a pack of frozen
raspberries. The rule for a profit-maximizing perfectly competitive firm is to
produce the level of output where Price= MR = MC, so the raspberry farmer
will produce a quantity of approximately 85, which is labeled as E'
in Figure5 (a). Remember that the area of a rectangle is equal to its base
multiplied by its height. The farm’s total revenue at this price will be shown by
the rectangle from the origin over to a quantity of 85 packs (the base) up to
point E' (the height), over to the price of $5, and back to the origin. The
average cost of producing 80 packs is shown by point C or about $3.50. Total
costs will be the quantity of 85 times the average cost of $3.50, which is shown
by the area of the rectangle from the origin to a quantity of 90, up to point C,
over to the vertical axis and down to the origin. The difference between total
revenues and total costs is profits. Thus, profits will be the blue shaded
rectangle on top.24

We calculate this as:

Profit = total revenue−total cost= $170

23
Edwin Mansfield, "Micro-Economics Theory and Applications, 3rd Edition", New York and London:W.W.
Norton and Company, 1979.

24
John Black, "Oxford Dictionary of Economics", New York: Oxford University Press, 2003.
Or, we can calculate it as:

Profit = (price–average cost) × quantity

= ($5.00–$3.50) × 85
=$170
Now consider Figure 5 (b), where the price has fallen to $2.75 for a pack of
frozen raspberries. Again, the perfectly competitive firm will choose the level
of output where Price = MR = MC, but in this case, the quantity produced will
be 75. At this price and output level, where the marginal cost curve is crossing
the average cost curve, the price the firm receives is exactly equal to its
average cost of production. We call this the break even point.25

The farm’s total revenue at this price will be shown by the large shaded
rectangle from the origin over to a quantity of 75 packs (the base) up to point E
(the height), over to the price of $2.75, and back to the origin. The height of
the average cost curve at Q = 75, i.e. point E, shows the average cost of
producing this quantity. Total costs will be the quantity of 75 times the average
cost of $2.75, which is shown by the area of the rectangle from the origin to a
quantity of 75, up to point E, over to the vertical axis and down to the origin. It
should be clear that the rectangles for total revenue and total cost are the
same. Thus, the firm is making zero profit. 26The calculations are as follows:

Profit = total revenue–total cost = (75) ($2.75) – (75) ($2.75)

=$0

Or, we can calculate it as:

Profit = (price–average cost) × quantity

= ($2.75–$2.75) × 75
= $0

In Figure 5 (c), the market price has fallen still further to $2.00 for a pack of
frozen raspberries. At this price, marginal revenue intersects marginal cost at a
quantity of 65. The farm’s total revenue at this price will be shown by the large
shaded rectangle from the origin over to a quantity of 65 packs (the base) up
to point E” (the height), over to the price of $2, and back to the origin. The
25
Black, 2003.
26
Roger LeRoy Miller, "Intermediate Microeconomics Theory Issues Applications, Third Edition", New York:
McGraw-Hill, Inc, 1982.
average cost of producing 65 packs is shown by Point C” or shows the average
cost of producing 50 packs is about $2.73. Total costs will be the quantity of 65
times the average cost of $2.73, which the area of the rectangle from the
origin to a quantity of 50, up to point C”, over to the vertical axis and down to
the origin shows. It should be clear from examining the two rectangles that
total revenue is less than total cost. Thus, the firm is losing money and the loss
(or negative profit) will be the rose-shaded rectangle.

The calculations are:

Profit = (total revenue– total cost)

= (65) ($2.00)–(65) ($2.73)
=$47.45

Or:

Profit = (price–average cost) × quantity

= ($2.00–$2.73) × 65
= $47.45

If the market price that perfectly competitive firm receives leads it to produce
at a quantity where the price is greater than average cost, the firm will earn
profits. If the price the firm receives causes it to produce at a quantity where
price equals average cost, which occurs at the minimum point of the AC curve,
then the firm earns zero profits. Finally, if the price the firm receives leads it to
produce at a quantity where the price is less than average cost, the firm will
earn losses27

If... Then...
Price > ATC Firm earns an economic profit
Price = ATC Firm earns zero economic profit
Price < ATC Firm earns a loss

27

Roger LeRoy Miller, "Intermediate Microeconomics Theory Issues Applications, Third Edition", New York:
McGraw-Hill, Inc, 1982. Edwin Mansfield, "Micro-Economics Theory and Applications, 3rd Edition", New
York and London:W.W. Norton and Company, 1979.
Henderson, James M., and Richard E. Quandt, "Micro Economic Theory, A Mathematical Approach. 3rd
Edition", New York: McGraw-Hill Book Company, 1980. Glenview, Illinois: Scott, Foresmand and Company,
1988.
John Black, "Oxford Dictionary of Economics", New York: Oxford University Press, 2003.
The Shutdown Point

The possibility that a firm may earn losses raises a question: Why can the firm
not avoid losses by shutting down and not producing at all? The answer is that
shutting down can reduce variable costs to zero, but in the short run, the firm
has already paid for fixed costs. As a result, if the firm produces a quantity of
zero, it would still make losses because it would still need to pay for its fixed
costs. Therefore when a firm is experiencing losses, it must face a question:
should it continue producing or should it shut down?

As an example, consider the situation of the Yoga Center, which has signed a
contract to rent space that costs $10,000 per month. If the firm decides to
operate, its marginal costs for hiring yoga teachers is $15,000 for the month. If
the firm shuts down, it must still pay the rent, but it would not need to hire
labor. Table 528 shows three possible scenarios. In the first scenario, the Yoga
Center does not have any clients, and therefore does not make any revenues,
in which case it faces losses of $10,000 equal to the fixed costs. In the second
scenario, the Yoga Center has clients that earn the center revenues of $10,000
for the month, but ultimately experiences losses of $15,000 due to having to
hire yoga instructors to cover the classes. In the third scenario, the Yoga Center
earns revenues of $20,000 for the month, but experiences losses of $5,000.29

In all three cases, the Yoga Center loses money. In all three cases, when the
rental contract expires in the long run, assuming revenues do not improve, the
firm should exit this business. In the short run, though, the decision varies
depending on the level of losses and whether the firm can cover its variable
costs. In scenario 1, the center does not have any revenues, so hiring yoga
teachers would increase variable costs and losses, so it should shut down and
only incur its fixed costs. In scenario 2, the center’s losses are greater because
it does not make enough revenue to offset the increased variable costs, so it
should shut down immediately and only incur its fixed costs. If price is below
the minimum average variable cost, the firm must shut down. In contrast, in
scenario 3 the revenue that the center can earn is high enough that the losses
diminish when it remains open, so the center should remain open in the short
run.

28
Frank (2008) 351.
29
Binger & Hoffman, Microeconomics with Calculus, 2nd ed. (Addison-Wesley 1998) at 312–14
Figure 630 illustrates the lesson that remaining open requires the price to
exceed the firm’s average variable cost. When the firm is operating below the
break-even point, where price equals average cost, it is operating at a loss so it
faces two options: continue to produce and lose money or shutdown. Which
option is preferable? The one that loses the least money is the best choice.

At a price of $2.00 per pack, as Figure 8.6 (a) illustrates, if the farm stays in
operation it will produce at a level of 65 packs of raspberries, and it will make
losses of $47.45 (as explained earlier). The alternative would be to shutdown
and lose all the fixed costs of $62.00. Since losing $47.45 is preferable to losing
$62.00, the profit maximizing (or in this case the loss minimizing) choice is to
stay in operation. The key reason is because price is above average variable
cost. This means that at the current price the farm can pay all its variable costs,
and have some revenue left over to pay some of the fixed costs. So the loss
represents the part of the fixed costs the farm can’t pay, which is less than the
entire fixed costs. However, if the price declined to $1.50 per pack, as Figure
8.6 shows (b), and if the firm applied its rule of producing where P = MR = MC,
it would produce a quantity of 60. This price is below average variable cost for
this level of output. If the farmer cannot pay workers (the variable costs), then
it has to shut down. At this price and output, total revenues would be $90
(quantity of 60 times price of $1.50) and total cost would be $165, for overall
losses of $75. If the farm shuts down, it must pay only its fixed costs of $62, so
shutting down is preferable to selling at a price of $1.50 per pack.

Figure 6 The Shutdown Point for the Raspberry Farm31 In (a), the
farm produces at a level of 65. It is making losses of $47.50, but price is
above average variable cost, so it continues to operate. In (b), total
30
Lovell (2004) p. 243
31
Kirzner (1981)
revenues are $90 and total cost is $165, for overall losses of $75. If the
farm shuts down, it must pay only its fixed costs of $62. Shutting down is
preferable to selling at a price of $1.50 per

Quantity Average Variable Average Marginal Cost

Q Cost Cost MC
AVC AC
0 - - -
10 $2.80 $9.00 $2.80
20 $2.40 $5.50 $2.00
30 $2.13 $4.20 $1.60
40 $1.90 $3.45 $1.20
50 $1.76 $3.00 $1.20
60 $1.72 $2.75 $1.50
70 $1.83 $2.71 $2.50
80 $2.10 $2.88 $4.00
90 $2.60 $3.29 $6.60
100 $3.38 $4.00 $10.40
110 $4.44 $5.00 $15.00
120 $5.44 $5.96 $31.50
Table 6 Cost of Production for the Raspberry Farm32

The intersection of the average variable cost curve and the marginal cost
curve, which shows the price below which the firm would lack enough revenue
to cover its variable costs, is called the shutdown point. If the perfectly
competitive firm faces a market price above the shutdown point, then the firm
is at least covering its average variable costs. At a price above the shutdown
point, the firm is also making enough revenue to cover at least a portion of
fixed costs, so it should limp ahead even if it is making losses in the short run,
since at least those losses will be smaller than if the firm shuts down
immediately and incurs a loss equal to total fixed costs. However, if the firm is
receiving a price below the price at the shutdown point, then the firm is not
even covering its variable costs. In this case, staying open is making the firm’s
losses larger, and it should shut down immediately. To summarize, if:
 price < minimum average variable cost, then firm shuts down
 price > minimum average variable cost, then firm stays in business

32
Garegnani (1990)
Short-Run Outcomes for Perfectly Competitive Firms

The average cost and average variable cost curves divide the marginal cost
curve into three segments, as Figure 8.7 shows. At the market price, which the
perfectly competitive firm accepts as given, the profit-maximizing firm chooses
the output level where price or marginal revenue, which are the same thing for
a perfectly competitive firm, is equal to marginal cost: P = MR = MC.

Figure 7 Profit, Loss, Shutdown We can divide marginal cost curve into three zones, based on
where it is crossed by the average cost and average variable cost curves. We call the point
where MC crosses AC the break even point. If the firm is operating where the market price is at a
level higher than the break even point, then price will be greater than average cost and the firm is
earning profits. If the price is exactly at the break even point, then the firm is making zero profits.
If price falls in the zone between the shutdown point and the break even point, then the firm is
making losses but will continue to operate in the short run, since it is covering its variable costs,
and more if price is above the shutdown-point price. However, if price falls below the price at the
shutdown point, then the firm will shut down immediately, since it is not even covering its variable
costs.33

First consider the upper zone, where prices are above the level where marginal
cost (MC) crosses average cost (AC) at the zero profit point. At any price above

33
Clifton (1977)
that level, the firm will earn profits in the short run. If the price falls exactly on
the break even point where the MC and AC curves cross, then the firm earns
zero profits. If a price falls into the zone between the break even point, where
MC crosses AC, and the shutdown point, where MC crosses AVC, the firm will
be making losses in the short run—but since the firm is more than covering its
variable costs, the losses are smaller than if the firm shut down immediately.
Finally, consider a price at or below the shutdown point where MC crosses AVC

Marginal Cost and the Firm’s Supply Curve

For a perfectly competitive firm, the marginal cost curve is identical to the
firm’s supply curve starting from the minimum point on the average variable
cost curve. To understand why this perhaps surprising insight holds true, first
think about what the supply curve means. A firm checks the market price and
then looks at its supply curve to decide what quantity to produce. Now, think
about what it means to say that a firm will maximize its profits by producing at
the quantity where P = MC. This rule means that the firm checks the market
price, and then looks at its marginal cost to determine the quantity to
produce—and makes sure that the price is greater than the minimum average
variable cost. In other words, the marginal cost curve above the minimum
point on the average variable cost curve becomes the firm’s supply. For
example, a lower price of key inputs or new technologies that reduce
production costs cause supply to shift to the right. In contrast, bad weather or
added government regulations can add to costs of certain goods in a way that
causes supply to shift to the left. We can also interpret these shifts in the firm’s
supply curve as shifts of the marginal cost curve. A shift in costs of production
that increases marginal costs at all levels of output—and shifts MC upward and
to the left—will cause a perfectly competitive firm to produce less at any given
market price. Conversely, a shift in costs of production that decreases marginal
costs at all levels of output will shift MC downward and to the right and as a
result, a competitive firm will choose to expand its level of output at any given
price34

34
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CONDITIONS OF EQUILIBRIUM OF FIRM AND
INDUSTRY

A firm is in equilibrium when it has no tendency to change its level

of output. It needs neither expansion nor contraction. It wants to
earn maximum profits in by equating its marginal cost with its
marginal revenue, i.e. MC = MR.

Diagrammatically, the conditions of equilibrium of the

firm are:
(1) The MC curve must equal the MR curve. This is the first order
and necessary condition. But this is not a sufficient condition which
may be fulfilled yet the firm may not be in equilibrium.

(2) The MC curve must cut the MR curve from below and after the
point of equilibrium it must be above the MR. This is the second
order condition.’ Under conditions of perfect competition, the MR
curve of a firm coincides with the AR curve. The MR curve is
horizontal to the X- axis. Therefore, the firm is in equilibrium when
MC=MR=AR (Price).35

35
Lee (1998)
In Figure 1(A), the MC curve cuts the MR curve first at point A. It
satisfies the condition of MC = MR, but it is not a point of maximum
profits because after point A, the MC curve is below the MR curve. It
does not pay the firm to produce the minimum output OM when it
can earn larger profits by producing beyond OM.

Point В is of maximum profits where both the conditions are

satisfied. Between points A and B. it pays the firm to expand its
output because it’s MR > MC. It will, however, stop further
production when it reaches the OM1 level of output where the firm
satisfies both the conditions of equilibrium.
If it has any plans to produce more than OM1 it will be incurring
losses, for its marginal cost exceeds its marginal revenue beyond the
equilibrium point B. The same conclusions hold good in the case of
a straight line MC curve as shown in Figure 1. (B)
An industry is in equilibrium: firstly when there is no tendency for
the firms either to leave or enter the industry, and secondly, when
each firm is also in equilibrium. The first condition implies that the
average cost curves coincide with the average revenue curves of all
the firms in the industry. They are earning only normal profits,
which are supposed to be included in the average cost curves of the
firms.36

The second condition implies the equality of MC and MR. Under a

perfectly competitive industry these two conditions must be
satisfied at the point of equilibrium, i.e.

MC = MR … (1)

AC = AR … (2)

MC = AC = AR37

 36
Petri, F. (2004), General Equilibrium, Capital and Macroeconomics, Cheltenham: Edward
Elgar.

 37
Kreps, D. M. (1990), A Course in Microeconomic Theory, New York: Harvester
Wheatsheaf.
SHORT RUN EQUILIBRIUM OF FIRM AND
INDUSTRY

Short-Run Equilibrium of the Firm:

A firm is in equilibrium in the short-run when it has no tendency to
expand or contract its output and wants to earn maximum profit or
to incur minimum losses. The short-run is a period of time in which
the firm can vary its output by changing the variable factors of
production. The number of firms in the industry is fixed because
neither the existing firms can leave nor new firms can enter it.

Assumptions:
This analysis is based on the following assumptions38
1. All firms use homogeneous factors of production.

2. Firms are of different efficiency.

3. Cost curves of firms vary from each other.

4. All firms sell their products at the same price determined by

demand and supply of the industry so that the price of each firm, P
(Price) = AR = MR.

5. Firms produce and sell different quantities.

The short-run equilibrium of the firm can be explained with the

help of marginal analysis and total cost- total revenue analysis.

(1) Marginal Cost-Marginal Revenue Analysis:

 38
Stigler J. G. (1987). "Competition", The New Palgrave: A Dictionary of Economics, Ist
edition, vol. 3, pp. 531–46.
During the short run, a firm will produce only if its price equals the
average variable cost or is higher than the average variable cost
(AVC). Further, if the price is more than the averages total costs
(SAC or АТС), i.e., P— AR > SAC, the firm will be earning
supernormal (or abnormal)

If price equals the average total costs, i.e., P = AR = SAC, the firm
will be earning normal (or zero) profits or breaks-even. If price
equals AVC, the firm will be incurring a loss. If price falls even a
little below AVC, the firm will shut down because in order to
produce it must cover at least its AVC during the short-run.

So during the short-run under perfect competition, a firm is in

equilibrium in all the above noted situations. We illustrate them
diagrammatically as under.39

Supernormal Profits:
The firm will be earning supernormal profits in the short-run when
price is higher than the short-run average cost, as shown in Figure 2
(A). The firm is in equilibrium at point E1 where SMC=MR and SMC
cuts MR from below. OQ, is the equilibrium output and OP (=Q1E1)
is the equilibrium price. Q1S are the short-run average costs.
SE1 (=Q1E1-Q1S) is the profit per unit. TS (equilibrium output) (per
unit profit) = TSE1P area is the supernormal profits.
Normal Profits:
The firm may earn normal profits when price equals the short-run
average costs as shown in Figure 2 (B). The firm is in equilibrium at
point E2 where SMC =MR and SMC cuts MR from below. OQ2 is the
equilibrium output and OP (=Q2E) is the equilibrium price. The firm
is earning normal profits because Price = AR = MR =SMC= SAC at
its minimum point E2.

 39
McNulty, P. J. (1967), "A note on the history of perfect competition", Journal of Political
Economy, vol. 75, no. 4 pt. 1, August, pp. 395–99
Minimum Loss:
The firm may be in equilibrium and yet incur a loss when price is
less than the short-run average costs, as shown in Figure 2 (C). The
firm is in equilibrium at point E3 where SMC = MR and SMC cuts
MR from below. OQ3 is the equilibrium output and OP (=Q3E3) is
the equilibrium price.
Since the average costs Q3B are higher than the price Q3E3, E3B is the
loss per unit (Q3B-Q3E3). The total loss is PE3 x E3B = PE3BA. The
firm will continue to produce OQ3 output so long as it is covering its
average variable cost plus some of its fixed cost.

40

Maximum Loss:
If the price fig. 2 falls to the level of AVC, the firm will just cover its
average variable cost, as shown in figure 2 (D). It is indifferent

 40
Garegnani, P. (1990), "Sraffa: classical versus marginalist analysis", in K. Bharadwaj and
B. Schefold (eds), Essays on Piero Sraffa, London: Unwin and Hyman, pp. 112–40 (reprinted
1992 by Routledge, London).
whether to operate or close down because its losses are the
maximum.

It will pay such a firm to continue producing OQ4 output and incur
PE4GF losses rather than close down in the short-run. OQ4 is the
shutdown output because if the price falls below OP, the firm will
stop production. E4 is, therefore, the shutdown point.
Shut Down Stage:
Figure 2. (E) shows a firm which is unable to cover even its AVC at
OQ0 level of output because the price OP is below the AVC curve. It
must shut down.
Thus in the short-run, there are firms which earn normal profits,
supernormal profits and incur losses.

41

(2) Total Cost-Total Revenue Analysis:

The short-run equilibrium of the firm can also he shown with the
help of total cost and total revenue curves. The firm is able to
maximize its profits when the positive difference between TR and
TC is the greatest. This is shown in Figure 3 where TR is the total
revenue curve and TC the total cost curve.

The total revenue curve is an upward sloping straight line curve

starting from O. This is because the firm sells small or large
quantities of its product at a constant price under perfect
competition. If the firm produces nothing, total revenue will be zero

 41
Novshek, W., and H. Sonnenschein (1987), "General Equilibrium with Free Entry: A
Synthetic Approach to the Theory of Perfect Competition", Journal of Economic Literature,
Vol. 25, No. 3, September, pp. 1281–306.
The more it produces, the larger is the increase in total revenue.
Hence the TR curve is linear and slopes upward.

The firm will maximize its profits at that level of output where the
gap between the TR curve and the TC curve is the maximum.
Geometrically, it is that level at which the slope of a tangent drawn
to the total cost curve equals the slope of the total revenue curve. In
Figure 3, the maximum amount of profit is measured by TP at OQ
output.

At outputs smaller or larger than OQ between A and B points, the

firm’s profits shrink. If the firm produces OQ1 output, its losses are
the maximum because the TC curve is above the TR curve. At Q1 its
profits are zero.
This is the break-even point of the firm. It starts earning profits
when it produces beyond OQ1 output level. At OQ2 level, its profits
are again zero. If it produces beyond this level, it incurs losses
because TC > TR.
Short-Run Equilibrium of the Industry:
An industry is in equilibrium in the short-run when its total output
remains steady, there being no tendency to expand or contract its
output. If all firms are in equilibrium, the industry is also in
equilibrium. For full equilibrium of the industry in the short-run, all
firms must be earning only normal profits.

The condition for this is SMC = MR = AR = SAC. But full

equilibrium of the industry is by sheer accident because in the
short- run some firms may he earning supernormal profits and
some incurring losses. Even then, the industry is in short-run
equilibrium when its quantity demanded and quantities supplied
are equal at the price which clears the market.

This is illustrated in Figure 4 where in Panel (A), the industry is in

equilibrium at point E where its demand curve D and supply curve S
intersect which determine OP price at which its total output OQ is
cleared. But at the prevailing price OP, some firms are earning
supernormal profits PE1ST, as shown in Panel (B), while some other
firms are incurring FGE2P losses, as shown in Panel (C) of the
figure.
 42

LONG RUN EQUILIBRIUM OF FIRM AND

INDUSTRY

Long-Run Equilibrium of the Firm:

The long run is a period of time in which the firm can change its
plant and scale of operations. Thus in the long-run all costs are
variable and there are no fixed costs. The firm is in the long-run

 42
Aumann, R. J. (1964), "Markets with a Continuum of Traders", Econometrica, Vol. 32, No.
1/2, Jan.–Apr., pp. 39–50.
equilibrium under perfect competition when it does not want to
change its equilibrium output.

It is earning normal profits. If some firms are earning supernormal

profits, new firms will enter the industry and supernormal profits
will be competed away. If some firms are incurring losses, some of
the firms will leave the industry till all earn normal profits.

Thus there is no tendency for firms to enter or leave the industry

because every firm must earn normal profits. “In the long-run,
firms are in equilibrium when they have adjusted their
plant so as to produce at the minimum point of their long-
run AC curve, which is tangent (at this point) to the
demand (AR) curve defined by the market price” so that
they earn normal profits.
Assumptions:43
This analysis is based on the following assumptions:
1. Firms are free to enter into or leave the industry.

2. All firms are of equal efficiency.

3. All factors are homogenous. They can be obtained at constant and

uniform prices. SMC

4. Cost curves of firms are uniform.

5. The plants of firms are equal, having given technology.

6. All firms have perfect knowledge about price and output.

Given these assumptions, each firm of the industry will be in long-

run equilibrium when it fulfils the following two conditions.

(1) In equilibrium, its short-run marginal cost (SMC) must equal to

its long-run marginal cost (LMC) as well as its short-run average

 43
Arrow, K. J. (1959), "Toward a theory of price adjustment", in M. Abramovitz (ed.), The
Allocation of Economic Resources, Stanford: Stanford University Press, pp. 41–51.
cost (SAC) and its long-run average cost (LAC) and both should
equal MR=AR=P.

Thus the first equilibrium condition is:

SMC = LMC = MR = AR = P = SAC = LAC at its minimum point,
and

(2) LMC curve must cut MR curve from below: Both these
conditions of equilibrium are satisfied at point E in Figure 5 where
SMC and LMC curves cut from below SAC and LAC curves at their
minimum point E and SMC and LMC curves cut AR = MR curve
from below. All curves meet at this point E and the firm produces
OQ optimum output and sells it at OP price.

44

Since we assume equal costs of all the firms of industry, all firms
will be in equilibrium in the long-run. At OP price a firm will have
neither a tendency to neither leave nor enter the industry and all
firms will earn normal profits.

Long-Run Equilibrium of the Industry:

The industry is in equilibrium in the long-run when all firms earn
normal profits. There is no incentive for firms to leave the industry
or for new firms to enter it. With all factors homogeneous and given
their prices and the same technology, each firm and industry as a

 44
Petri, F. (2004), General Equilibrium, Capital and Macroeconomics, Cheltenham: Edward
Elgar.
whole are in full equilibrium where LMC = MR = AR (-P) = LAC at
its minimum.

Such an equilibrium position is attained when the long-run price for

the industry is determined by the equality of total demand

45

The long-run equilibrium of the industry is illustrated in Figure 6

(A) where the long-run price OP is determined by the intersection of
the demand curve D and the supply curve S at point E and the
industry is producing OM output. At this price OP, the firms are in
equilibrium at point A in Panel (B) at OQ level of output where LMC
= SMC = MR =P ( = AR) = SAC = LAC at its minimum.

At this level, the firms are earning normal profits and have no
incentive to enter or leave the industry. It follows that when the
industry is in long-run equilibrium, each firm in the industry is also
in long-run equilibrium.

 45
Stigler J. G. (1987). "Competition", The New Palgrave: A Dictionary of Economics, Ist
edition, vol. 3, pp. 531–46.
CONCLUSION
The perfect market economy model introduces the concepts of utility
maximization, general equilibrium, substitution at the margin and the concept
of social and private efficiency. The model is both socially- and privately
efficient because all imperfections are assumed away. The model
demonstrates that what is good for consumers and producers are also good for
society

Perfect competition, in the long run, is a hypothetical benchmark. For

market structures such as monopoly, monopolistic competition, and
oligopoly, which are more frequently observed in the real world than
perfect competition, firms will not always produce at the minimum of
average cost, nor will they always set price equal to marginal cost. Thus,
these other competitive situations will not produce productive and
allocative efficiency. Moreover, real-world markets include many issues
that are assumed away in the model of perfect competition, including
pollution, inventions of new technology, poverty which may make some
people unable to pay for basic necessities of life, government programs
like national defence or education, discrimination in labour markets, and
buyers and sellers who must deal with imperfect and unclear
information.

However, the theoretical efficiency of perfect competition does provide a

useful benchmark for comparing the issues that arise from these real-
world problems.
BIBLIOGRAPHY

BOOKS REFFERED:

1. D. Salvator: Micro Economic, harper- Collins, 1991

2. H.L. Ahuja: Advanced Economic Theory, S. Chand and Company, New

Delhi.

3. H.L. Ahuja: Uchchatar Arthik Siddhant, S.Chand & Co., New Delhi

4. Laxminarayan Nathuramka: Vyasti Arthshastra, College Book House,

Jaipur.

5. R.H. Left witch: price System and Resource Allocation (Hindi &
English)

6. Samuelson and Nordhans: Economics

7. J.P. Gould and C.E. Ferguson: Micro Economic theory Revised by J.P.
Gould and e. P.

Laser, All India Traveller book