Determination of Short Run Equilibrium of a Firm

Meaning

• Industry demand curve (DD): Total quantity demanded by all consumers at each possible price.
• Industry supply curve (SS): Total quantity supplied by all firms at each possible price.
• Short-run equilibrium of the industry occurs where DD intersects SS.

How price and quantity are determined

Let the demand curve DD and supply curve SS intersect at point E.

Equilibrium price = OP
Equilibrium quantity = OQ

• If price is above OP (say OP₁), quantity supplied > quantity demanded → excess supply → price falls.
• If price is below OP (say OP₂), quantity demanded > quantity supplied → excess demand → price rises.
• At E (OP, OQ), there is neither excess demand nor excess supply, so the price has no tendency to change. 

Once the industry has fixed the market price, OP, each individual firm behaves as a price-taker.

Why the firm is a price-taker

• Each firm is very small relative to the industry. Its own output changes are too small to affect total supply and market price.
• The firm can sell any quantity within its capacity at price OP, but it cannot charge more than OP.
• If it charges more, buyers will shift to other firms; if it charges less, it will only lose revenue unnecessarily.

Shape of the firm’s demand curve

• The firm faces a perfectly elastic demand curve at price OP.
• Its demand curve is a horizontal straight line at the level of price OP.
• For a perfectly competitive firm:

Price (P) = Average Revenue (AR) = Marginal Revenue (MR) at every output level.

The firm’s short-run equilibrium is found by combining:

• Its short-run cost curves (SMC, SAC, AVC), and
• The P = AR = MR line it faces.

The firm chooses that output at which its profit is maximised or loss is minimised.

First condition: profit-maximising output

• The firm is in equilibrium when:
  SMC = MR and SMC cuts MR from below.
• Under perfect competition, MR = P = AR, so:
  SMC = P and SMC cuts the price line from below.

At this output, any small increase or decrease in output would lower its profit or increase its loss.

Second condition: profit or loss decision

At the output where SMC = MR, the firm compares AR (= P) with:

• SAC (short-run average cost) and
• AVC (average variable cost).

Three short-run outcomes are possible:

1. AR > SAC → supernormal (abnormal) profit.
2. AR = SAC → normal profit (no supernormal profit, no loss).
3. AVC ≤ AR < SAC → loss, but the firm continues to produce (covers all variable costs and part of fixed costs).

If AR < AVC, the firm shuts down in the short run.

In all cases, assume:

• P = AR = MR = constant horizontal line.
• SMC curve intersects this line from below at point E → equilibrium output OQ.

(i) Supernormal (abnormal) profit (AR > SAC)

At equilibrium output OQ:

Price/AR = EQ
Average cost = SQ on SAC

• Since AR > AC (EQ > SQ), the firm earns profit per unit = ES.
• Total supernormal profit = shaded rectangle ESBP (profit per unit × quantity).

Intuition: A very efficient firm with low costs or a short-run demand boom can earn profit above normal profit.

(ii) Normal profit (AR = SAC)

At equilibrium output OQ:

Price/AR line is tangent to SAC at point E.
AR = AC = EQ.

• The firm covers all costs, including the normal profit of the entrepreneur.
• There is no supernormal profit and no loss.

Intuition: This is a long-run sustainable situation; the entrepreneur is just sufficiently rewarded.

(iii) Loss but continued production (AVC ≤ AR < SAC)

At equilibrium output OQ:

AR = EQ
AC = SQ (above AR)

• Since AC > AR, the firm incurs loss per unit = SE.
• Total loss = area of rectangle BSEP.
• However, because price > AVC, the firm covers all variable costs and some of its fixed costs.
• If it stopped producing, it would lose the entire fixed cost; by producing, it reduces the loss.

Intuition: An airline may run flights even with a low passenger load if ticket revenue pays for fuel and crew and contributes something to fixed charges.

Now consider different possible prices: P₀, P₁, P₂, and P₃.

Shut-down point (P₀, AR = AVC)

• At P₀: P₀ = AR₀ = MR₀.
• SMC cuts MR₀ from below at E₀, giving minimum supply OQ₀.
• At OQ₀: Price = AR = AVC and AR < AC.
• The firm covers only variable cost; total loss equals fixed cost.
• Shutdown point: AR = AVC.

• • If price falls below P₀ (AR < AVC), the firm shuts down in the short run and produces zero.

Break-even point (P₁, AR = AC)

• At P₁: P₁ = AR₁ = MR₁.
• SMC cuts MR₁ at E₁, giving output OQ₁.
• At OQ₁: AR = AC = EQ; the firm covers all costs (variable + fixed).
• Break-even point: AR = AC → no profit, no loss.

• Industry determines market price via the intersection of DD and SS.
• An individual firm under perfect competition is a price-taker and faces a P = AR = MR horizontal demand curve.
• Short-run equilibrium of a firm: SMC = MR, and SMC cuts MR from below.
• The short-run supply curve of the firm is the rising part of SMC above minimum AVC.