UNIT – 4
Economics
In economics, the theory of production and cost states that the cost of a product is determined by the sum total of the cost of all the resources that went into making it. There are multiple factors to be considered when determining the cost of a product. The various theories and types of costs that come under this topic are given as follows.
PRINCIPLE UNDER PERFECT IMPERFECT, SHORT AND LONG PERIOD MARKEETING, EQUILIBRIUM OF FIRM:
A. EQUILIBRIUM CONDITIONS
A firm applies the principle of marginal cost (MC) and marginal revenue (MR) while deciding to produce its output.
We have explained how an individual firm accepts its price determined in the market by aggregates demand and supply. At that price (per units) a firm can sell all that it wants to sell. The price line here is a straight horizontal one. In perfect competition we can obtain a firm’s average revenue (AR) by PxQ=TR/Q=AR, that is
PxQ=
=AR
Therefore, P=AR
Here price line and average revenue line are identical. Marginal (MR)is equal to ∆TR, that is a change in TR. Since the firm sells the total quantity for the same price per unit, it is change in TR (∆TR) which is equal to P.
Since P=AR and also P=MR, therefore P=AR=MR.
Bringing MC and MR together, we can decide the equilibrium output of a firm in perfect competition
The firm cannot stop its production at E, as the marginal cost till that point is higher than marginal revenue resulting in loss. From point E to E1, marginal cost is lower than marginal revenue bringing more revenue than cost. Therefore, to maximise profit the firm must produce upto the point where (i)MC=MR and (ii)MC must cut MR from below or MC at the point of equilibrium must be increasing.
When the above two conditions are fulfilled, the firm’s output is at equilibrium point.
We analysis the equilibrium of the firm with the help of the following assumptions:
- The firm is rational i.e. it tries to maximise profit.
- Perfect competition in product market.
- Perfect competition in factor market. This assumption implies identical cost of production to all the firms.
- The firm operates under U shape cost curve.
- Price of the product is determined by the aggregate demand and aggregate supply.
- The firm is a price taker.
B. SHORT-RUN EQUILIBRUIM OF A FIRM
We are familiar with the concept of short-run as discussed under the cost analysis. In the short run there is a distinction between fixed cost and variable cost. The firm operates within the given cost structure and capacity. The number of firms in the market remains constant. There is no entry or exit from the market. The price is determined in the market by demand for and supply of industry’s output. The price thus determined is accepted by the firm, turning the firm into a price taker. Given the price, demand and cost, the rational firm aiming at maximization of profit produces output upto the point of equilibrium i.e. MC=MR and MC is increasing at the point of equilibrium.
A firm being in equilibrium does not necessarily earn profit. It only means the firm observes the equilibrium rules to determines its output and sells it at the prevailing price. By doing so the firm may earn excess profit, normal profit or even may incur loss.
(a) Excess Profit:
The firm accepts the market price OP. At OP price the firm is in equilibrium at N. At point N the firm fulfils the equilibrium conditions i.e. MC = MR and MC is increasing at that point. By dropping a perpendicular from N to the X-axis, we measure the total output produced i.e. OQ.
The firm’s total revenue (TR) is worked out by multiplying output (OQ) by price (OP).
TR=OPxOQ=OQNP
Total cost is worked out by multiplying output by average cost which is obtained at the point where QN line cuts average cost (AC) curve at point R.
TC=OQxQR=OQRS
The firm’s equilibrium position with excess profit is explained below.
Price = OP
Output = OQ
TR = OQNP
TC = OQRS
Profit = TR –TC
=OQNP – OQRS
=SRNP
The firm earns excess profit = SRNP
Excess profit is the profit earned by a firm over and above the normal profit.
It is also called supernormal profit.
(b) Normal Profit:
The second possibility is that a firm fails to earn excess profit but earns only normal profit. In fig. The firm is in equilibrium at N1 with normal profit. The firm’s operational position is:
Price = OP1 AC= Q1N1
Output = OQ1 TC= OQ1N1P1
TR = OQ1N1P1 π = TR – TC
= OQ1N1P1 – OQ1N1P1
= Normal Profit
As, TR = TC, there is no excess profit.
The firm in this case earns only normal profits.
Normal Profit is that amount of profit which keeps a person in business. Opportunity cost is one of the important factors that decides the normal profit to be earned by a firm. In economic analysis normal profit is part and parcel of the cost. When a firm covers the total cost it earns normal profit. In the short-run a business firm may not earn normal profit, but it must earn it in long-run. In fig. At OP1 price TR = TC, where the firm earns only normal profit.
The possibility of earning normal profits in the short-run is rather rare. It implies that the entire industry will settle-down in the short-run itself which is highly imporabables.
(c) Loss or Sub-normal profit
When the firm fails to earn normal profits it still continues to operates but incurring loss. Fig. Shows the loss incurred
If the market price happens to be OP2, the firm is in equilibrium at N2, producing OQ2 output.
TR = OQ2N2P2
TC = OQ2TS
= TC>TR
Loss = P2N2TS
The loss is termed as sub normal profit.
The firm operates in the short-run with loss. The important question that does arise is, should the firm continue to function with loss? How much loss can it bear? The answer to this question depends on the nature of cost, i.e. fixed and variable cost, in other word unavoidable and avoidable cost. In the short-run a firm must endure what it cannot avoid and must not suffer from what it can avoid. Fig. Brings out the distinction between the two types of costs.
.OP price, the firm is in equilibrium at R, producing OQ output. Its revenue and costs are:
Output = OQ TC = ACxOQ = OQLT
Price = OP TFC = KJLT
TR = OQRP TVC = OQJK
TR>TC but TR>TVC
The loss incurred is equal to a part of the fixed cost i.e. PRLT. It covers the entire variable cost (OQJK) and also a part of the TFC i.e. KJRP. What is necessary for the firm is to cover the total variable cost which otherwise is an avoidable cost. The fixed cost has to be incurred even if the firm is closed, unless the firm wants to quit the business which is not a wise decision in the short-run. The firm continue to function since its TR is more than its TVC which enables it to cover a part of TFC.
(d) Shut-Down Point
At price OP1, in fig. The firm produces OQ1, output and earns total revenue just equal to total variable cost (TR=TVC). The firm is in equilibrium at S, where its TR (OQ1 SP1) is equal to TVC (OQ1 SP1).S is the shut down point. It is the shut-down point in the sense that any further decline in price will compel the firm to close down its operation. In fact one could term this point as starting point since the production starts at this point where TR = TVC.
Fig. Explains the situations where the firm requires to close down and wait for better times to come.
At price OP, if the firm decides to produce its equilibrium output OQ, its TVC = OQSN and TR = OQRP. The TR<TVC by the amount PRSN> the firm’s total loss is PRMT which is made up partly of PRSN of TVC and NSMT the total fixed cost. At this price (OP), the firm is not in position to cover even the variable cost. Therefore, the best advice for the firm is to close down and wait for the price to go up or the cost to decline so that it can cover atleast the TVC and possibly cover the TFC too.
LONG-RUN EQUILIBRIUM OF A FIRM
Long-run is a time period where all the costs are variable. The firm can expand or contract its capacity as required. New firms may enter the market if the existing firms earn excess profit. Those firms who cannot cover the total cost would leave the market. Thus in the long-run there is entry to and exist from the market. The firm which remains in the market will earn only normal profit. Fig. Shows the long-run equilibrium of the firm.
The long-run position of the firm is-
Output = OQ TC = ACxQ = OQxQS = OQSP
Price = OP TR = ARxQ = OPxOQ = OQSP
The firm earns normal profit as its TR = TC.
The firm earns normal profit at a technical point where
P = AR = MR = AC = MC.
In fig. At point S the firm is at technical point mentioned above. At this point, the firms TR = TC giving the firm only the normal profit.
EQUILIBRUIM OF INDUSTRY AND FIRM
Industry is in equilibrium when all firms are equilibrium. It usually takes place only in the long-run. New firms are attracted to the industry due to excess profit earned by the existing firms. Those who incur loss leave the industry. Entry of new firms out the excess profits. Similarly, the exist of loss incurring firms, will enable the remaining firms to earn normal profits. Thus, the firms earning normal profit alone will remain in the long run as shown in fig. A & B.
Fig . A depicts the industry where aggregate demand and supply determine the price. Fig .B shows the equilibrium position of a firm. At OP1 price in the market, the firm produces OQ1 output and earns excess profit=NLTP1. Attracted by this supernormal profit, more firms enter the market and supply curve shifts to right. The increased supply shown by SS supply curve brings down the price to OP. At OP which is a lower price the firm produces less and earns only normal profit and is in equilibrium at E. Its (OQEP) is equal to its TC (OQEP).
In this article, we shall take up two forms of imperfect competition:
(a) Monopoly
(b) Monopolistic competition
Monopoly
There is only one firm prevailing in a particular industry called A Monopoly Market Structure. When a single firm controls 25% or more of a particular market is known as monopoly power from a regulatory view. Indian Railway is an example.
A Natural Monopoly Market Structure comprises various natural advantages like strategic location and/or abundant mineral resources.
Various gulf countries have a monopoly in crude oil exploration because of abundant naturally occurring oil resources.
Key features of a Monopoly Market Structure
Lack of Substitutes
Barriers to Entry
Competition
Price Maker
Profits structure
1. Lack of Substitutes
In monopoly structure firms normally produce a good without close substitutes. The product is generally often specific and unique.
For example, when Apple started producing the iPad, it arguably had a monopoly over the tablet market.
2. Barriers to Entry
There are significant barriers exists to entry set up by the monopolist. If new firms want to enter the industry, the monopolist will not have complete control of a firm on the supply.
This implies that there is no difference between a firm and an industry Under monopoly.
3. Competition
In a monopoly market structure, there are no close competitors in the market for that product.
4. Price Maker
The term Price Determination under Imperfect Competition symbolizes monopoly market. The monopolistic sets the price of the product. Since it has market power, This power makes the monopolist a price maker.
5. Profits
A monopolist can maintain supernormal profits in the long run but it not necessary that he earns profits too. He can be making a loss or maximizing revenues. This can never happen under perfect competition.
In the case where the abnormal profits are available in the long run, other firms will also enter the market and as a result, abnormal profits will be eliminated.
Revenue curves under a Monopoly
A monopolistic firm is a price-maker, not a price-taker. Therefore, a monopolist can increase or decrease the price. Also, when the price changes, the average revenue, and marginal revenue changes too. Take a look at the table below:
Quantity Sold Price per unit Total Revenue
(TR) Average Revenue
(AR) Marginal revenue
(MR)
1 6 6 6 6
2 5 10 5 4
3 4 12 4 2
4 3 12 3 0
5 2 10 2 -2
6 1 6 1 -4
Let’s look at the revenue curves now:
Monopoly definition
As you can see in the figure above, both the revenue curves (Average Revenue and Marginal Revenue) are sloping downwards. This is because of the decrease in price. If a monopolist wants to increase his sales, then he must reduce the price of his product to induce:
The existing buyers to purchase more
New buyers to enter the market
Hence, the demand conditions for his product are different than those in a competitive market. In fact, the monopolist faces demand conditions similar to the industry as a whole.
Therefore, he faces a negatively sloped demand curve for his product. In the long-run, the demand curve can shift in its slope as well as location. Unfortunately, there is no theoretical basis for determining the direction and extent of this shift.
Talking about the cost of production, a monopolist faces similar conditions that a single firm faces in a competitive market. He is not the sole buyer of the inputs but only one of the many in the market. Therefore, he has no control over the prices of the inputs that he uses.
A Firm’s Short-Run Equilibrium in Monopoly
Like in perfect competition, there are three possibilities for a firm’s Equilibrium in Monopoly. These are:
The firm earns normal profits – If the average cost = the average revenue
It earns super-normal profits – If the average cost < the average revenue
It incurs losses – If the average cost > the average revenue
Normal Profits
A firm earns normal profits when the average cost of production is equal to the average revenue for the corresponding output.
Equilibrium in Monopoly
In the figure above, you can see that the MC curve cuts the MR curve at the equilibrium point E. Also, the AC curve touches the AR curve at a point corresponding to the same point. Therefore, the firm earns normal profits.
Super-normal Profits
A firm earns super-normal profits when the average cost of production is less than the average revenue for the corresponding output.
Equilibrium in Monopoly
In the figure above, you can see that the price per unit = OP = QA. Also, the cost per unit = OP’. Therefore, the firm is earning more and incurring a lesser cost. In this case, the per unit profit is
OP – OP’ = PP’
Also, the total profit earned by the monopolist is PP’BA.
Losses
A firm earns losses when the average cost of production is higher than the average revenue for the corresponding output.
Equilibrium in Monopoly
In the figure above, you can see that the average cost curve lies above the average revenue curve for the same quantity. The average revenue = OP and the average cost = OP’. Therefore, the firm is incurring an average loss of PP’ and the total loss is PP’BA. In the short-run, a monopolist sometimes sets a lower price and incurs losses to keep new firms away.
Summary of Short-run Equilibrium in Monopoly
In the short-run, a monopolist firm cannot vary all its factors of production as its cost curves are similar to a firm operating in perfect competition. Also, in the short-run, a monopolist might incur losses but will shut down only if the losses exceed its fixed costs. Further, if the demand for his product is high, then the monopolist can also make super-normal profits.
Equilibrium in Monopoly
The figure shown above depicts a firm’s short-run Equilibrium in Monopoly. The quantity is along the X-axis and price and cost of production along the Y-axis.
There are three curves – the average variable cost (AVC) curve, the average total cost (ATC) curve, and the marginal cost (MC) curve. Further, there are three demand curves to explain the possible positions of the equilibrium:
Demand Curve D1 is tangent to the AVC curve at point E1
Its corresponding MC curve intersects the MR1 curve from below at point A1. Therefore, while the monopolist satisfies the first condition of equilibrium, he is unable to recover his complete cost of production.
However, even if he closes the plant down, he cannot reduce the losses since they are fixed costs.
Therefore, he decides to produce – OM1 quantity of output and sells it at a price E1M1. This ensures that he suffers a loss which is equal to his fixed costs.
It is important to note that if the demand curve lies left to the position of D1, then there is no production since the monopolist would simply add to his losses by operating the plant. In such cases, a monopolist would close down the plan and restrict his losses to the fixed costs.
Demand curve D2
If the demand curve lies to the right of D1, then the monopolist can recover a part of his fixed costs. Further, if this demand curve is tangent to the ATC curve (demand curve D2), then the monopolist can also recover his complete cost of production.
If D2 is the demand curve, then the equilibrium position of the monopolist is at the intersection of the MC curve and the MR2 curve at point A2. This corresponds with the point of tangency between D2 and the ATC curve (point E2).
Therefore, the MC curve cuts the MR2 curve from below and AR = ATC. Hence, the monopolist earns normal profits by producing a quantity OM2 and selling it at a price E2M2.
Demand Curve D3
If the demand curve lies further to the right of D2 (like D3), the monopolist can earn super-normal profits. The equilibrium position is the point of intersection between the MC curve and the MR3 curve at point A3. Therefore, the monopolist produces a quantity OM3 and sells it at a price E3M3.
A Firm’s Long-run Equilibrium in Monopoly
In the long-run, a monopolist can vary all the inputs. Therefore, to determine the equilibrium of the firm, we need only two cost curves – the AC and the MC. Further, since the monopolist exits the market if he is operating at a loss, the demand curve must be tangent to the AC curve or lie to the right and intersect it twice.
Equilibrium in Monopoly
As you can see above, there are two alternative cases for the determination of Equilibrium in Monopoly:
With normal profits
With super-normal profits
We have not taken the loss scenario here because if the monopolist incurs losses in the long-run, he will stop operating.
Case 1
The demand curve AR1 is tangent to AC or LAC at point E. Remember, if the demand curve lies to the left of the AC curve, then the monopolist is unable to recover his costs and closes down.
However, if the AR curve is tangent to the AC curve, then the monopolist can recover his costs and stay in the market.
Further, note that the perpendicular drawn from point E to the X-axis, the MC curve, and the MR curve are concurrent at point A.
Therefore, all the conditions of equilibrium are satisfied. The monopolist produces OM quantity and sells it at a price of EM per unit which covers its average costs + normal profits.
Case 2
The marginal revenue curve MR2 cuts the MC curve from below at point B. The corresponding height of the AR2 curve is E’M1.
Hence, the monopolist produces OM1 quantity and sells it at E’M1 per unit to earn an extra profit of E’B per unit. Being a monopoly, this extra profit is not lost to competition or newer firms entering the industry.
