Equilibrium Conditions for a Firm

Equilibrium Conditions for a Firm

Equilibrium of the firm means that the firm reaches the maximum profit. Now, there are two approaches (TC = TR) for calculating the maximum profits

Total curve approach; and, ii. Marginal curve approach (MC = MR)

1. Total curve approach

In the TC-TR Approach, profit is obtained by a firm, through the difference between the TC and the TR. Equilibrium is obtained at the point where maximum difference between the TC and TR occurs. This TC-TR method is not generally adopted in the calculation of maximum profit. Hence to calculate profit / loss, economists resort to the MC=MR approach. Shaded area denotes profit. Profit is maximum when Q = 5

2. Marginal curve Approach

In this approach, the following two conditions are to be verified to obtain equilibrium of a firm.

i. MC = MR

Look at the following hypothetical situation. A rational seller will not be in equilibrium at output level 1, though MC=MR at that point, since continuing production, his profit increases. When he produces an output beyond 1 unit till he reaches 5 units, his MC < MR. It is advantageous for the producer to continue his production.

Again, he will not be in equilibrium beyond 5 units of Q, when his MC > MR, implying that the seller incurs loss.

Therefore, he is said to be in equilibrium, i.e., at the point of maximum profit when his MC is equal to MR. Hence, MC = MR is the first condition for the equilibrium. (Note: This is a necessary condition but not a sufficient condition).

ii. MC cuts MR curve from below (Sufficient conditions)

A firm under perfect competition faces a horizontal price line. (It is also the AR curve and the MR curve). A firm under imperfect competition focuses declining price line. The MC is U-shaped and it cuts MR at two points, both from above (i.e., at point A) and also from below (i.e., at point B), as shown in the diagram.

Only at point B, the equilibrium condition is fulfilled. Thus for equilibrium under all market situations the two conditions viz., MC = MR; and MC cuts MR from below.

Market Structure