Pricing in the Short Run: Equilibrium of the Firm
Short period is the span of time so short that existing plants cannot be extended and new plants cannot be erected to meet increased demand. However, the time is adequate enough for producers to adjust to some extent their output to the increase in demand by overworking their fixed capacity plants. In the short run, therefore, supply curve is elastic.
Figure 3 shows the average and marginal cost curves of the firm together with its demand curve. Demand curve, in a perfectly competitive market, is also the average revenue curve and the marginal revenue curve of the firm. The marginal cost intersects the average cost at its minimum point. The U-shape of both the cost curves reflects the law of variable proportions operative in the short run during which the size of the plant remains fixed. The firm is in equilibrium at the point B where the marginal cost curve intersects the marginal revenue curve from below.
LARGE NUMBER OF BUYERS AND SELLER
The market under perfect competition includes a large number of small sellers that no single seller is able to exert significant influence over price. Each individual firm supplies only a small fraction of the total supply offered in the market. Sellers are price takers who can sell all that they can produce at market-determined price. Similarly there is large number of small buyers that no buyer can affect the price. All buyers are price-takers too.
HOMOGENEOUS PRODUCT
All firms in the perfectly competitive market produce a homogeneous product. One firm’s output cannot be distinguished from that of other producers. As a result, purchasing decisions are based entirely on price. If the firm sets its price above the market-determined level, its buyers will go away to other sellers. Price-cutting is unnecessary because producers can sell their total output at the market price.
FREE ENTRY AND EXIT
Perfect competition assumes free entry and exit from an industry. If market-determined price is greater than average cost, firm earns super-normal profits, resources can be mobilized to create new firms or to expand the production capacity of existing firms. If profits are below average cost resources can easily be transferred from the industry to produce other products at higher profit rates.
PROFIT MAXIMIZATION
Firms pursue no other goals. The goal of all firms is profit maximization.
NO GOVERNMENT INTERVENTION
The perfect competition rules out government intervention in the market in the form of tariffs, subsidies, rationing of production or demand.
PERFECT MOBILITY
The factors of production (labor and capital) can freely move from one firm to another throughout the economy. The assumption implies that workers can move between different jobs and the labor is not unionized. Raw materials and other factors are not monopolized. In brief, there is perfect competition in the factor-market.
PERFECT KNOWLEDGE
All buyers and sellers are assumed to have complete knowledge of the market not only of the prevailing conditions in the current period but in all future periods and so rules out the uncertainty about future developments in the market.
Price Determination under Perfect Competition
Perfect competition is defined as a market situation where there are a large number of sellers of a homogeneous product. An individual firm supplies a very small portion of the total output and is not powerful enough to exert an influence on the market price. A single buyer, however large, is not in a position to influence the market price. Market price in a perfectly competitive market is determined by the interaction of the forces of market demand and market supply. Market demand means the sum of the quantity demanded by individual buyers at different prices. Similarly, market supply is the sum of quantity supplied by the individual firms in the industry. Each seller and buyer takes the price as determined. Therefore, in a perfect competition, the main issue for a profit- maximizing firm is not to determine the price of its product but to adjust its output to the market price so that profit is maximized. Price determination under perfect competition is analyzed under three different time periods:
(a) Market period
(b) Short run
(c) Long run
(i) Market period
In a market period, the time span is so short that no firm can increase its output. The total stock of the commodity in the market is limited. The market period may vary depending upon the nature of the product. For example, in the case of perishable commodities like vegetables, fish, eggs, the period may be a day. Since the supply of perishable commodities is limited by the quantity available or stock in day that neither can be increased nor can be withdrawn for the next period, the whole of it must be sold away on the same day, whatever may be the price.
The equilibrium point shift from R to R” and the price rises to OP’. In this situation, price is determined solely by the demand condition that is an active agent.
Similarly if the demand for a product is given as shown in demand curve SS in figure 2 . If the supply of the product decreases suddenly from SS to S’S’, the price increases from P to P’. In this case price is determined by supply, the supply being an active agent. In this case supply curve shifts leftward causing increase in price of the reduced supply goods. Given the demand curve dd and supply curve SS, the price is determined at OP. Demand curve remaining the same, the decrease in supply shifts the supply curve to its left to S’S’. Consequently, the price rises from OP to OP’.
The firm supplies OQ output. The QC is the average cost and the firm earns total profit equal to the area shown by ABCD. The firm maximizes its profit. Earlier to the point of equilibrium, the firm does not attain the maximum profit as each additional unit of output brings more revenue that its cost. Any level of output greater than OQ brings less marginal revenue than marginal cost. For the equilibrium of a firm the two conditions must be fulfilled:
(a) The marginal cost must be equal to the marginal revenue. But, this condition is not sufficient, since this condition may be fulfilled, yet the firm may not attain equilibrium. Accompanying figure shows that
marginal cost is equal to marginal revenue at point e’, yet the firm is not in equilibrium as Oq output is greater than Oq’
(b) The second and necessary condition for equilibrium requires that the marginal cost curve cuts the marginal revenue curve from below i.e. the marginal cost curve be rising at the point of intersection with the marginal revenue curve.
Thus, a perfectly competitive firm will adjust its output at the point where its marginal cost is equal to marginal revenue or price, and marginal cost curve cuts the marginal revenue curve from below.
The fact that a firm is in equilibrium does not imply that it necessarily earns supernormal profits. In the short-run equilibrium firms may earn super-normal profits, normal profits or may incur losses.
Whether the firm makes supernormal profits, normal profits or incurs losses depends on the level of the average cost at the short run equilibrium. If the average cost is below the average revenue, the firm earns supernormal profits.
Figure 5 illustrates that the average cost QC is less than average revenue QB, and the firm earns profits equal to the area ABCD.
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