“A firm is a unit engaged in the production for sale at a profit and with the objective of maximizing profit.” -Watson
A firm is in equilibrium when it is satisfied with its existing level of output. The firm wills, in this situation produce the level of output which brings in greatest profit or smallest loss. When this situation is reached, the firm is said to be in equilibrium.
“Where profits are maximized, we say the firm is in equilibrium”. -Prof. RA. Bilas
“The individual firm will be in equilibrium with respect to output at the point of maximum net returns.” -Prof. Meyers
Conditions of the Equilibrium of Firm
A firm is said to be in equilibrium when it satisfies the following conditions:
- The first condition for the equilibrium of the firm is that its profit should be maximum.
- Marginal cost should be equal to marginal revenue.
- MC must cut MR from below.
The above conditions of the equilibrium of the firm can be examined in two ways:
- Total Revenue and Total Cost Approach
- Marginal Revenue and Marginal Cost Approach.
1. Total Revenue and Total Cost Approach
A firm is said to be in equilibrium when it maximizes its profit. It is the point when it has no tendency either to increase or contract its output. Now, profits are the difference between total revenue and total cost. So in order to be in equilibrium, the firm will attempt to maximize the difference between total revenue and total costs. It is clear from the figure that the largest profits which the firm could make will be earned when the vertical distance between the total cost and total revenue is greatest.
In fig. 1 output has been measured on X-axis while price/cost on Y-axis. TR is the total revenue curve. It is a straight line bisecting the origin at 45°. It signifies that price of the commodity is fixed. Such a situation exists only under perfect competition.
TC is the total cost curve. TPC is the total profit curve. Up to OM1 level of output, TC curve lies above TR curve. It is the loss zone. At OM1 output, the firm just covers costs TR=TC. Point B indicates zero profit. It is called the break-even point. Beyond OM1 output, the difference between TR and TC is positive up to OM2 level of output. The firm makes maximum profits at OM output because the vertical distance between TR and TC curves (PN) is maximum.
The tangent at point N on TC curve is parallel to the TR curve. The behaviour of total profits is shown by the dotted curve. Total profits are maximum at OM output. At OM2 output TC is again equal to TR. Profits fall to zero. Losses are minimum at OM] output. The firm has crossed the loss zone and is about to enter the profit zone. It is signified by the break-even point-B.
2. Marginal Revenue and Marginal Cost Approach
Joan Robinson used the tools of marginal revenue and marginal cost to demonstrate the equilibrium of the firm. According to this method, the profits of a firm can be estimated by calculating the marginal revenue and marginal cost at different levels of output. Marginal revenue is the difference made to total revenue by selling one unit of output. Similarly, marginal cost is the difference made to total cost by producing one unit of output. The profits of a firm will be maximum at that level of output whose marginal cost is equal to marginal revenue.
Thus, every firm will increase output till marginal revenue is greater than marginal cost. On the other hand, if marginal cost happens to be greater than marginal revenue the firm will sustain losses. Thus, it will be in the interest of the firm to contract the output. It can be shown with the help of a figure. In fig. 2 MC is the upward sloping marginal cost curve and MR is the downward sloping marginal revenue curve. Both these curves intersect each other at point E which determines the OX level of output. At OX level of output marginal revenue is just equal to marginal cost.
It means, firm will be maximizing its profits by producing OX output. Now, if the firm produces output less or more than OX, its profits will be less. For instance, at OX1 its profits will be less because here MR = JX1, while MC = KX1 So, MR > MC. In the same fashion at OX2 level of output marginal revenue is less than marginal cost. Therefore, beyond OX level of output extra units will add more to cost than to revenue and, thus, the firm will be incurring a loss on these extra units.
Besides first condition, the second order condition must also be satisfied, if we want to be in a stable equilibrium position. The second order condition requires that for a firm to be in equilibrium marginal cost curve must cut marginal revenue curve from below. If, at the point of equality, MC curve cuts the MR curve from above, then beyond the point of equality MC would be lower than MR and, therefore, it will be in the interest of the producer to expand output beyond this equality point. This can be made clear with the help of the figure.
In figure 3 output has been measured on X-axis while revenue on Y-axis. MC is the marginal cost curve. PP curve represents the average revenue as well as marginal revenue curve. It is clear from the figure that initially MC curve cuts the MR curve at point E1. Point E1 is called the ‘Break Even Point’ as MC curve intersects the MR curve from above. The profit maximizing output is OQ1 because with this output marginal cost is equal to marginal revenue (E2) and MC curve intersects the MR curve from below.