What is Firm?

• A Firm is a group of people, with production tools,

located in some premises, who, with work, transform
raw materials into goods and services, and sell them
• Can also be defined as a business unit which owns,
controls and manages a plant or plants, where plant
refers to the technical unit

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 What is an Industry then???
•A group of Firms producing a
homogeneous products is called
Industry and conversely we can say
a Firm is the company that operates
within the Industry to create that
product
• An Industry is the name given to a certain
type of manufacturing or retailing environment
For example, the retail industry is the industry that
involves everything from clothes to computers
• You can presume KFC as one firm, but all the fast
food restaurants and their suppliers would make up
the fast food Industry

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 The four forms of market
There are basically four types of market in economics that
we consider while understanding many different concepts.
1. Perfectly Competitive Market
2. Monopoly Market
3. Oligopolistic Market
4. Monopolistic Competition
Perfectly competitive market has a number of buyers and
sellers which means that no party can dominate the
exchange process. Both the parties are price takers which
means that they have to accept what is being offered to
them. Let’s say if the price of a product is around 20$ then
both the seller and the buyer have no other option than to
accept whatever the price is being set.
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 The four forms of market cont…
In monopoly form of market there is only one seller in the market which means that the
seller actually sets the price. The buyers have no option other than to accept the price and
get on with it. The buyer leaves the good if he/she cannot afford the price set by a
monopolistic firm. A perfect example in this regard is that of Cable Television Company which
is under contract with other companies in a specified area. This means that no other
company can work in the XYZ area thus having full option of setting the price they want to.
The next type of market is oligopoly in which there are few sellers of not identical but similar
products. In this type of market, the competition is not aggressive as seen in the perfect
competition but still companies do sometimes tend to consider the steps taken by the
oligopolistic rivals. Different companies in oligopoly can unison to form a cartel and act as
monopoly.
Last type of market is monopolistic competition in which there are many sellers and the
products they are offering are slightly differentiated. Due to the slight change in their nature,
each seller can set its own price depending on the response from the sellers.

To conclude, it has to be said that understanding the types of market in economics is really
important in order to fully grasp the more complex concepts like supply and demand.
Let us understand them individually…

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 What is the Perfect Competition?
• First referring to Competition which involves one Firm trying to
take away market share from another Firm and this process is a
rivalry among the Firms
under Perfect Competition-
• There are large number of buyers and sellers of the homogeneous
product in the market
• Well-informed producers and consumers about the market
• Only one price of a commodity in the whole market
• Free entry (for new firms) and free exit (for old firms)
• Price of a commodity is determined by the Industry and at the
determined price all the Firms can sell any number of units of the
commodity
• So under perfect competition the firm is price-taker not a price-
maker

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 AR and MR Curves Under Perfect
Competition
Q AR (P) TR MR
1 10 10 10
2 10 20 10
3 10 30 10
4 10 40 10
5 10 50 10
6 10 60 10
7 10 70 10

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 AR and MR Curves Under Perfect
Competition
• AR(Average revenue) curve and MR(Marginal Revenue) curve
under perfect competition becomes equal to D(Demand)
curve and it would be a horizontal line or parallel to the X-
axis
• The curve simply implies
that a firm under perfect
Perfectly Elastic Demand
competition can sell
Curve(AR=MR=D)
as much quantity as
it likes at the given Price D
price determined by the
industry
i.e. a perfectly
elastic demand curve
0 1 2 3 4
Commodity 7
Now the Meaning of Firm equilibrium
• ‘Equilibrium’ means a state of rest from which there
is no net tendency to move
• So the Firm’s Equilibrium means, “the level of output
where the firm is maximizing its profits and
therefore, has no tendency to change its output”.
• In this situation either the Firm will be earning
maximum profit or incurring minimum loss i.e. it
refers to the profit maximization
• In the words of Hansen, “A Firm will be in
equilibrium when it is of no advantage to increase or
decrease its output”.

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 Necessary Conditions For The Firm
Equilibrium
• Profit of a Firm is equal to the difference between
its total revenue (TR) and the total cost (TC) i.e.,
(Profit=TR-TC) and so for the equilibrium of the
Firm it should be maximum
• Marginal cost should be equal to Marginal revenue
(MC=MR)
And when these are equal profit is maximum
 Equality of MR and MC is necessary but not
sufficient, so the sufficient condition is that MC
curve should cut the MR curve from below not from
the above
• No firm has an incentive to change its behavior

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 Contd..
 There are two points at which MR (=AR) =MC but at
both the points the Firm can’t be in equilibrium or
can’t have maximum profit
 As stated before, as a sufficient
condition for the
equilibrium MC curve
should cut the MR curve MC

from below which is

Cost / Revenue
point A B A

AR=MR

O N M
Output
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 Firm Equilibrium Under Perfect
Competition In Two Time Periods
 As a matter of fact, the price of a good is determined
at a point where its demand is equal to supply and so
further it depends on the time taken by the demand
and supply to adjust themselves
 So this time element plays a vital role in determination
of price of the goods
 Acc. to Alfred Marshall - If the period is short, price
determination will be influenced more by the demand,
on the other hand, if the period is long it will be
influenced more by the supply
 So the two periods we have to study-
 Short Period
 Long Period
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 Short Run Firm Equilibrium
• In Short run, the Firm output (supply) can be changed only
by the variable factors (like labor force through
overtime),
fixed factors (like machinery) can’t be changed
• There is not enough time for new Firms to enter the
Industry.
• Further, if the demand is increased, the supply can be
increased only up to its existing production capacity
• A firm in Short Run Equilibrium may face one of these
situations
 Super Normal Profits
 Normal Profits
 Suffer Minimum Losses
 Shut Down Point
• For the analysis of these situations Short-run Average
Cost curve (SAC) will be introduced
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 Super-Normal Profits : AR>SAC
• A Firm in Equilibrium earns super normal profit, when
average revenue (price per unit) determined by the
Industry is more than its short-run average cost (SAC)
• Firm equilibrium point=E, where MR (=AR) = SMC
• Equilibrium output=OM
 Since AR(EM)>SAC(AM) Super Normal Profit
Firm is earning EA super SMC
normal profit per unit of

Cost / Revenue
SAC
P E
output
Total super normal profit
of the Firm on OM output B A
AR=MR
=BAxEA (OMxEA)=EABP
=Shaded area

O M 13
Output
 Normal Profits : AR=SAC
• A Firm in Equilibrium earns normal profit, when average
revenue (price per unit) determined by the Industry is
equal to its short-run average cost (SAC)
• Firm equilibrium point=E, where MR (=AR) = SMC
• Equilibrium output=EM
 At this output AR and SAC
SAC
both are equal to EM and SMC

Firm is earning normal

Cost / Revenue
P E
profit per unit of output
 It results in no gain in AR=MR

terms of money for an

entrepreneur as this
profit is included in the
cost of production
O M
Output 14
 Minimum Loss : AR<SAC
• A Firm may continue production even if it is incurring losses
because in sort run, it can’t leave the Industry
• Obviously in this situation of loss, a Firm will be in equilibrium at
that level of output where it gets the minimum losses i.e. when
SAC is more than AR
• At equilibrium AR=EM and
SAC=AM and also from
SAC
graph AR<SAC Loss
 Firm’s per unit loss=AE SMC

Cost / Revenue
i.e. (AM-EM) Total loss B A
at OM level of output
=OMxAE i.e. EABP
 Even if Firm discontinues P E AR=MR
the production, it will have
to bear the loss of fixed
cost which is minimum
possible loss of a Firm
O M
Output 15
 Shut down Point : AR<SAC : AR=SAVC
• The firm will shut down if it cannot cover average variable costs i.e when
AR=SAVC
• A firm should continue to produce as long as price is greater than average
variable cost
• Once price falls below that
point it makes sense to shut
SAC
down temporarily and save SMC
the variable costs SAVC
• If prices rises to OP1

Cost / Revenue
B A
than Firm can cover some
of its Fixed costs also P1
• So the minimum point of
AR1=MR 1
SAVC is called Firm’s
Shut down point
P E AR=MR
 The shutdown point is
the point at which the Shut-down
firm will gain more by point
M
shutting down than it will
O
by staying in business Output 16
 Long Run Firm Equilibrium
• In Long run, the Firm’s output (supply) can be changed by
both the variable factors and fixed factors i.e. all factors
become variable
• There is enough time for new Firms to enter the Industry
• Further, if the demand is increased, the supply can be
increased or decreased according to the demand
• Summarizing, in long run a Firm can make all sorts of
changes
• For Long run equilibrium, long run marginal cost (LMC) is
equal to MR and LMC curve cut the MR curve from below
• In case of long run equilibrium, all the firms will earn only
normal profits
even if there are other situations of short run they will
sustain only few a times

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 Contd..
• Take the case when the Firm earn super-normal profit-
 Then the existing Firm will increase their production
and new Firm will enter the Industry
 Consequently, the total supply will increase and price
fall down and further results in normal profit for the
firm
• On the contrary, if the firm is incurring losses
 Then some Firm will leave the Industry which will
reduce the total supply
 And due to decrease in supply, price will rise and once
again Firm will begin to earn normal profit
 The normal profit of a firm is also termed as zero
economic profit as this is included in the cost of
production not in the economic profit
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 Contd..
• Firm equilibrium is at the minimum point of its LAC and at
this point the Firm will get the normal profits
• If AR (price) rises to OP1, then Firm’s LMC cuts its MR1
at E1 and the firm LAC

gets super-normal profit

LMC
but again come to OP
P1 E1
yielding normal profits

Cost / Revenue
as stated before AR1=MR 1
E
 And at price OP2 Firm P
incurs losses but again E2 AR=MR
rise to level OP to
P2
maintain the equilibrium AR2=MR2
at normal profit
 Firms equilibrium:
MC=MR=AR=min LAC O M2 M M1
Output 17