EQUILIBRIUM OF FIRM: BY CURVES OF MARGINAL REVENUE AND MARGINAL COST
We know that a firm will be in equilibrium when it is earning maximum profits. We shall see presently
that for a firm, to make maximum profits. two conditions arc essential:
(i) Marginal Revenue = Marginal Cost. and (ii) MC curve cuts MR curve from below at the
equilibrium point. It is obvious that total profits can be increased by expanding output as long as the addition to the total revenue resulting from the sale of extra unit of output is greater than the addition io the total cost caused by producing an extra output. Now the addition to total revenue and total cost due to an extra unit of output are nothing else but marginal revenue and marginal cost respectively. Thus. a firm will go on expanding output as long as marginal revenue exceeds marginal cost of production. If. at any output. marginal revenue falls short of marginal cost. if an additional unit of output adds less to total revenue than to total cost. the firm will contract output to avoid losses and thus increase its profits” The level of output when’ and are equal is the profit
The whole argument can be explained with the where MC is the marginal cost curve and MR the marginal revenue curve. AC ami AR are the average cost and average revenue curves respectively. At the output OM. marginal cost equals marginal revenue (MR and MC curves intersect at E above this point). This represents the point of maximum profits and hence of equilibrium. At outputs smaller than OM. marginal revenue exceeds marginal cost and hence-there is scope for increasing profits by increasing output. For example, at output OL, marginal revenue is LG and the marginal cost is LH. and LG is greater than LH. It means that by producing the L1h unit, the firm is adding more to revenue than to its cost and, therefore, it will be profitable for it to produce the L1h unit. Similarly, for evcry other unit till the Mth one, the marginal revenue exceeds marginal cost, and, therefore, the firm can increase its total profits by producing up to OM output. If the firm stops producing at OL, the units of output which could have added more money to thc firm’s revenue than to its cost would not have been produced and profits would have been smaller by the area GHE than they could have been. Thus, a firm has an incentive to produce up to 0 1 level of output.
Hence, we conclude that firm’s profits at OM output are the maximum and that’ limn when laminar Ctlt libidinal This is one condition which is necessary but which is not sufficient for equilibrium. the total profits earned by the firm in the equilibrium position The easily found. At output OM, the average cost iDM while the average revenue is QM. Therefore. the profit per unit will be equal to QD and the total profits will he equal to the rectangle DIRT. At an equilibrium position, the curve t cut the The condition that for a firm.
Librium marginal cost must equal marginal revenue is no doubt a necessary condition but not a sufficient condition of equilibrium. For attaining equilibrium, a second condition must also be satisfied, ‘.;z., that the marginal cost (Me) curve must cut the marginal revenue (MR) curve from below at the point of equilibrium. This means that, beyond the equilibrium output, marginal cost must be greater than marginal revenue. If this condition is not met. a firm will not be earning maximum profits and hence will not be in equilibrium. as we shall see in the diagram below the point E (i.e., output OM) satisfies this second conditions also, as the Me curve cuts the MR curve from below at E and Me is greater than MR beyond E. It will be clearly not profitable. therefore. to expand output beyond OM. But there can be such a cost-revenue situation, which satisfies the first condition of Me being equal to MR but the second condition of Me cutting MR curve from below is not met.
MR is the straight line marginal revenue curve (as we have already seen. a straight line marginal curve is actually faced by a firm under perfect competition). Me is the marginal cost of the firm. t point T where Me and MR intersect, the marginal
cost equals marginal revenue but from the figure it is clear thai at T marginal cost curve Me is cutting marginal revenue curve MR from above and, therefore. marginal cost is less than the marginal revenue beyond the point T. Obviously. T cannot be a position of equilibrium since after T. marginal cost is less than marginal revenue and it will be profitable for the firm to expand output. At T or output ON. the firm instead of making maximum profit is making maximum losses. At point P in the same figure. however, marginal cost curve is cutting marginal revenue curve (rom below and marginal cost beyond the point P is greater than marginal revenue. Hence. if the firm expands output beyond P (i.e.• OM output). it will be adding more to cost than to revenue -clearly an unprofitable move. Thus. we conclude that in this figure. the point P, and not point T is the maximization. In this equilibrium position. the firm is producing equilibrium output OM. Similarly. point E (a) cannot be a position of equilibrium though Me equals MR at this point. This is because at E marginal cost curve is cutting the marginal revenue curve from E. both Me and MR curves are falling downwards. yet Me is falling more steeply than MR. Therefore. beyond E. MR is greater than Me. Hence, it will be profitable for the firm to expand output. Hence. E cannot be the position of firm’s equilibrium. For the firm to be in equilibrium.(a) Me beyond E must rise upwards to cut the MR curve from below. If it docs not rise upwards beyond E, then there can be no def mite position of equilibrium in cost-revenue situation presented It should be carefully noted that point (b) is really a position of equilibrium under the given cost-revenue situation. At S. Me equal 1R and also Me curve is cutting MR curve from belo . Although at S both Me and MR are falling downwards, yet Me is falling less Rapidly than MR and. therefore. beyond S. Me is greater than MR. It will be nonprofit
These two conditions of equilibrium hold good both in the short run as well as in the long run. Whether
the period is short or long, a firm aims at maximisation of profits and the profits arc maximised only when the above two conditions are satisfied. But there is one difference. In the short run, it the short-run marginal cost curve and in the long run, it is the long-run marginal cost curve which is relevant for comparing with the marginal revenue curve. Again, these two fundamental conditions, marginal cost being equal to marginal revenue and MC curve cutting MR curve from below, are valid whether a finn is working under perfect competition, Monopoly or imperfect competition. The difference lie only in the shape of the marginal revenue and marginal co t curves. Under perfect competition, MR and AR curves are horizontal straight lines and they coincide.but under imperfect competition MR and AR curves are downward sloping.