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A firm is defined as the economic entity which employs factors of production to produce commodities that it sells to other people. The only a firm can sustain itself is to maintain a level of income where it has no incentive for it to increase or decrease output from that level. That level is known as Equilibrium of a Firm. We shall look at just that below.
A firm is said to be in equilibrium when it selects a particular level of output at which it would like to 'stay' or 'rest'; there is no incentive for it to increase or decrease output from that level. But before we go further into this topic, we must understand the concept of Equilibrium Price.
Equilibrium refers to a situation in which the quantity demanded of a commodity equals the quantity supplied of the commodity. It refers to the balance between the opposing forces of demand and supply. The price at which the quantity demanded of a commodity equals the quantity supplied is known as Equilibrium Price. It can also be seen as the price at which the consumers are willing to purchase the same quantity of a commodity which producers are willing to sell. The amount that is bought and sold at equilibrium price is known as Equilibrium Quantity.
In the diagram above, we see the demand and supply curve. The 2 curves are intersecting at a particular point. This price at this point is the Equilibrium Price and the quantity at this point is the Equilibrium Quantity. If the price is above the Point of Equilibrium, there is an excess of supply. If the price is below the Point of Equilibrium, there is an excess of demand.
Equilibrium of Firm
Having understood the concept of equilibrium price, let us now look at the Equilibrium of a Firm. A firm is defined as the economic entity which employs factors of production to produce commodities that it sells to other people. A firm is the basic unit of production. It performs 2 kinds of functions in an economy:
It buys factor services largely from households, and uses them to produce goods and services
It transforms inputs into outputs.
As mentioned above, a firm is said to be in equilibrium when it selects a particular level of output at which it would like to 'stay' or ' rest'; there is no incentive for it to increase or decrease output from that level. This occurs, usually, when firms are earning profits. A firm is in equilibrium when, given demand and cost conditions, it produces that level of output at which profit is maximised.
Profit - Maximisation Objective
A firm is in equilibrium when it maximises its profits. It is in equilibrium in the sense that if the firm selects that level of output at which profit is maximised, it would like to produce that level of output. There is no reason and incentive for the firm to change the level of output.
Profits are defined as the difference between the revenue that the firm earns from selling its output and the cost of producing that output.
TP = TR - TC
Where, TP stands for total profit, TR stands for total revenue, and TC stands for total costs.
When the difference between TR and TC is maximised, profit would be maximised, thus, the firm will be in a state of equilibrium.
Rules for Profit - Maximisation (under a perfectly competitive firm)
As stated above, a firm is said to be in equilibrium when it selects that level of output at which it makes maximum profits. Since a firm is in a state of equilibrium when it maximises profits, the rules for profit maximisation are the rules for equilibrium. These rules are common to all the firms operating under different market structures.
There are 2 ways of explaining how a firm reaches its equilibrium level by maximising profits:
Total Revenue (TP) and Total Cost (TC) Approach
Marginal Revenue and Marginal Cost Approach.
Total Revenue and Total Cost Approach
Equilibrium of a firm can be explained with the help of TR and TC curves. Total profit is defined as the excess of TR over TC. Therefore, total profit (TP) is maximised when TR-TC is maximum. Hence, a firm will maximise its profits at the level of output where the difference between TR and TC is the largest. We can see this graphically below.
In the graph above, the X-axis represents Output, and the Y-axis represents TR, TC and TP. As we can see in the graph, the TR curve is a straight line curve as it goes increasing at a constant rate. The TC curve starts on point A on the Y-Axis. The curve indicates an increase at a diminishing rate and then at an increasing rate. It is clear that up to OL level of output, TC > TR, so the firm is incurring losses. At the point of OL, the firm is at Break - Even Point. It neither is at a loss, nor does it gain any profits. From OL onwards, we see the TR curve above the TC curve, indicating that the total revenue is more than the total cost of production. As output increases, TP starts increasing and then peaks and starts decreasing till point ON. At point OM, we see that the difference between TR and TC is greatest. It is at this point that the firm is maximising its profits. It is at a production level of OM that the company is in a state of equilibrium.
Marginal Revenue and Marginal Cost Approach
This approach requires three rules that must be satisfied for profits to be maximised. These rules are as follows:
A rule to decide whether or not to produce in the short-run - In the short-run, a firm should produce if and only if P or AR (average revenue) is equal to or greater than AVC (average variable cost or TR or TVC (total variable cost)
A rule that is necessary for profits to be maximised - A necessary condition for the firm to be producing its profit - maximising output is that MR should be equal to MC.
A rule to ensure that profits are maximised rather than minimised - For equality of MC with MR to ensure profit - maximisation rather than profit - minimisation, it is sufficient that MC be less than MR at a slightly lower output and that MC exceeds MR for a slightly higher output.
It is clear from the above that maximising profits is essential for a firm to reach a state of equilibrium. It is essential for firms to follow either of the steps mentioned above to reach a state of equilibrium so that it can sustain itself and grow.