Equilibrium of Firm and

Industry: Definitions, Conditions

and Difficulties
Equilibrium of Firm and Industry: Definitions, Conditions
and Difficulties!
The word equilibrium has been taken from science. It is a state of no
change where opposite forces become equal.

The consumer is in equilibrium when he is getting maximum

satisfaction from his income.

Similarly, for an industry, equilibrium refers to a situation when there

is no tendency for new firms to enter or exit. Now, the question arises,
under what conditions such equilibrium situations will be achieved.

Equilibrium of Firm:
“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:
1. The first condition for the equilibrium of the firm is that its profit
should be maximum.

2. Marginal cost should be equal to marginal revenue.

3. MC must cut MR from below.

The above conditions of the equilibrium of the firm can be

examined in two ways:
1. Total Revenue and Total Cost Approach

2. 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.
A. Determination of Short Run Equilibrium of Firm:

Short-run refers to that period in which fixed factors remaining

unchanged the firms in order to incur maximum profits can vary their
output by changing the variable factors like labour, raw material etc.
In the short period, it is not necessary that the firms must earn super-
normal or normal profits but even the firms may have to sustain the
losses.

A firm may earn supernormal profits because in the short run, firms
cannot enter the industry. Moreover, a firm may suffer losses, because
in the short run, may not step up production even when price of the
product falls. In case, it stops production temporarily, it will have to
bear the loss of fixed cost which will constitute the minimum losses of
the firm.
However, all the above stated possibilities have been
explained as under:
(i) Supernormal Profits:
A firm is said to be in equilibrium when its marginal cost is equal to
marginal revenue and marginal cost curve cuts the marginal revenue
curve from below. A firm in equilibrium enjoys supernormal profits if
average revenue exceeds marginal cost. This fact has been shown in fig
4.

In figure 4 outputs has been shown on horizontal axis and revenue on

vertical axis. MC and AC are the marginal cost and average cost curves
respectively. PP is the average revenue curve. It is clear from the figure
that MC curve intersects the MR curve from below at point N which
shows output OX. At this level of output price is NX and average cost
is MX. Since average revenue is greater than average cost, the firm is
earning super-normal profits MN per unit of output. Thus, the total
super-normal profits of a firm will be equal to PLMN.

(ii) Normal Profit:

Normal profits refer to those profits where the average cost of the firm
equals the average revenue. These profits cover just the reward for
entrepreneurial services and are included in the cost of production. It
can be shown with the help of a figure. In figure 5 the equilibrium has
been depicted at point E. At point E marginal revenue is equal to
marginal cost and marginal cost intersects the marginal revenue curve
from below. The firm earns normal profits at OX output because at
this output both the conditions of equilibrium are fulfilled.

(iii) Minimum Losses:

A firm in equilibrium incurs losses when it does not cover the average
cost. In other words, when average revenue falls short of average cost,
the firm has to sustain losses. In figure 6 the firm is said to be in
equilibrium at point T. At this level of output both the conditions of
equilibrium are satisfied i.e., marginal revenue is equal to marginal
cost and marginal cost curve intersects the marginal revenue curve
from below. Thus, it determines the OX level of output
correspondingly price is OP. It means loss per unit of output is RT.
Therefore, losses will be PSTR.

(iv) Shut Down Point:

Simple question is why firms continue producing the product if they
are making losses. In the short run, the firms cannot go out of the
industry by disposing off the plant. Why do they not shut down? It is
because they cannot change the fixed factors and they have to face
fixed costs even if the firm is shut down.

The firm can avoid only variable costs but it has to bear the fixed costs
whether to produce or not. The firm will continue producing till the
price covers the average variable cost. If the price covers some part of
the average fixed costs besides the variable costs, the producer will
continue producing. Thus the firm will continue producing so long as
price exceeds average variable cost. The shut down point can be shown
with the help of a diagram.

In diagram 7 equilibrium is at E where MR = MC and MC cuts MR

from below. The price is EQ and OQ is the output. This price covers
the average variable cost. Average cost corresponding to this output is
AQ. In that way loss per unit is AE which is equal to average fixed cost.
The total losses are equal to total fixed costs. If price is slightly below
OP, level, the firm will not produce at all. The firm will simply shut
down production and wait for some good days to come.

Shut Down Point (Losses=Total Fixed Costs):

However, the firm may continue to operate even under such
a situation because of the following reasons:
1. The firm may continue to operate because a higher valuation (value)
is given to an ongoing concerns rather than a closed down firm.
2. More prestige is attached to the owner or manager of a on-going
concern than to that of a firm that has closed down or ceased to
operate.

3. By keeping the operation going, the firm will not lose competent
personnel.

4. The firm may continue to operate in the hope of earning profits in

future.

B. Determination of Long Run Equilibrium of the Firm:

Long run refers to that period in which the producer can change its
supply by changing all the factors of production. In other words, the
producer has the sufficient time to adjust their supplies according to
the changed demand conditions.

Moreover, new firms can also enter and existing firms can leave the
industry. In the long-run, the firm is said to be in equilibrium when
marginal cost is equal to price. Besides it, the firm under perfect
competition to be in equilibrium-price must be equal to average cost.
Generally, in the long run, firm in equilibrium earns normal profits. If
the firms happen to earn the super normal profits in the long period,
the existing firms will increase their production.

Lured by super normal profits some new firms will enter into the
industry. The total supply of the product will increase and the price
falls down. Thus, due to fall in price the firms will get normal profits.
In case price of the product is less than the average cost, the firms
would make losses. These losses would induce some firms to leave the
industry. Consequently the output of the industry will fall which will
raise the price, hence, the firms will begin to earn normal profits. It
can be shown with the help of a figure 8.
In figure 8 output has been depicted on X-axis while revenue on Y-
axis. SAC is the short run average cost curve and LAC is the long run
average cost curve. Similarly, SMC and LMC are the short run
marginal cost and long run marginal cost curves respectively.

Let us suppose that the industry determines OP price. At this price

firms are producing with SAC1 and is earning super normal profits
equal to the shaded area PLNM. Lured by these super normal profits,
the existing firms will increase their production capacity, thus, the new
firms will enter the industry. As a result of the entry of the new firms
supply of the product will increase which will lead to a fall in price.

Thus, the price will fall to OP’. At this price, the firm will be in
equilibrium at point E and will produce OQ level of output. It is due to
the reason that at point E, marginal revenue, long run marginal cost,
average revenue and long run average cost are all equal and the firm
earns normal profits.

Symbolically:
MR = LMC = AR = LAC = SAC = SMC = Price
Difficulties of TR-TC Approach:
The main difficulties of TR and TC approach are as under:
1. It is very difficult to analyze at what level of output profits are
maximum.

2. It is difficult to see at a glance the maximum vertical distance

between TR and TC approach.
3. It is very difficult to discover the price per unit of output.

Equilibrium of Industry:
The group of firms producing homogeneous product is called industry.
In fact the concept of industry exists only under perfect competition.
An industry is said to be in equilibrium when it has no tendency to
increase or decrease its level of output.

According to Prof. Hansen, “An industry will be in equilibrium when

there is no tendency for the size of the industry to change i.e., when no
firms wish to leave it and no new firms are being attracted to it.” New
firms will have no tendency to enter the industry when existing firms
are enjoying normal profits. The normal profits earned by a firm are
included in total cost.

In this way equilibrium for the industry means that firms are neither
moving in or nor moving out. It means that the level of profits in it is
neither above nor below the normal level and hence is equal to it.

Conditions of Equilibrium of an Industry:

1. Constant Number of Firms:
An industry will be in equilibrium when the number of firms remains
constant. In this situation, no new firms will enter and no old firms
will leave the industry.

2. Equilibrium of Firms:
An industry will be in equilibrium when all firms operating in it are in
equilibrium and have no tendency to increase or decrease the level of
output.

(i) Short Run Equilibrium of Industry:

In the short run, the industry is said to be in Equilibrium when all the
firms operating under it are in equilibrium. But for the industry to be
in full equilibrium in the short run is very rare. Full equilibrium
position is possible when firms earn normal profits. In the short run
firms can also earn supernormal profits or incur losses. It can be
shown with the help of fig. 9.
In fig. 9 (A) DD is the industry’s demand curve and SS represents the
supply curve. Both these curves intersect each other at point E which
establishes equilibrium of the industry. At this equilibrium point,
industry sets price OP and produces OQ level of output. But, it will not
be the full equilibrium of the industry.

In fig. B the firms are enjoying supernormal profits as indicated by

ABED. In fig. 9 C, the firms are incurring losses equal to the shaded
area PERT. In the long run, firms incurring losses will leave the
industry. On the other hand, firms getting supernormal profits will
expand their production capacity. Lured by supernormal profits new
firms will enter the industry. Consequently, industry will be in
equilibrium in the short run only if all firms are enjoying normal
profits.

(ii) Long Run Equilibrium of the Industry:

The long run equilibrium of the industry can be shown with the help of
a figure 10. In the long run the industry will be in equilibrium at a
point where long run supply (LRS) is equal to long run demand (LRD).
This determination of price is OP and output OQ. The firm will follow
this price and will be in equilibrium at E1. Here, the firms will earn just
normal profits. Thus, according to Left-witch, “The existence of long
run industry equilibrium requires long run individual equilibrium at
no profit no loss level of operation”.