Short run equilibrium of the firm

Since a firm in a perfectly competitive market is a price-taker, it has to adjust its level of output to maximise its profit. The aim of any producer is to maximise his profit. The short run is a period in which the number and plant size of the firms are fixed. In this period, a firm can produce more only by increasing the variable inputs. As the entry of new firms or exit of the existing firms is not possible in the short run, the firm, in a perfectly competitive market, can either earn super-normal profit or normal profit or incur loss. When the firm only meets its average cost (AC), it earns normal profits and normal profit is also included in average total cost. Normal profit is the normal rate of return on capital and remuneration for the risk bearing factor of an entrepreneur. It is also called as break-even point. The diagram shows that MR = MC at E. The equilibrium output is OQ. Since AR=AC or OP=EQ, the firm earns normal profits.

Example

The cost of producing 1,000 units of pens is ₹ 25,000, the entrepreneur invests ₹ 1,00,000 in the business and the normal rate of return in the market is 10%. Thus, he must earn at least ₹ 10,000 (₹ 1,00,000 x 10%). This ₹ 10,000 will be shown as cost. Thus, the cost of production would be ₹ 35,000. If the firm is selling the pens at ₹ 35 per unit, it earns normal profits because AR = AC = ₹ 35.

Super-normal profits

When the AR of a firm is equal to its average total cost (ATC), it earns normal profits. When a firm earns super-normal profits, its AR is more than AC. Thus, a firm earns profits in addition to the normal rate of profit.

Example

In the above case, if the firm sells pens at ₹ 45 per unit, it would be earning super-normal profits because AR > AC. The super-normal profit would be ₹ 10 (45-35) per pen. A firm can enjoy excess profit in the short run when AR > AC. In the above figure, price is EQ = OP, cost is BQ = AO, so the profit is EB = PA. The figure shows that in order to attain equilibrium, the firm tries to equate MR with MC. MR is a horizontal line and the MC curve cuts the MR curve at point E. At E, MR=MC. OQ is the equilibrium output of the firm. The total profit APEB is highlighted in the shaded area of the diagram.

Losses Here, the AR is lesser than the AC. At the equilibrium point E, AR = EQ and AC = BQ. Since BQ > EQ, the firm incurs a loss of BE per unit and the total loss is ABEP which is indicated by the shaded area.

Example

In the above case, if the firm sells the pen at ₹ 30, then it is incurring a loss because AR < AC. The loss will be (₹ 35 - ₹ 30) = ₹ 5 per unit.

Note: Under perfect competition, when price line becomes tangent to the minimum point of AVC, it is called shut down point.  