Useful Notes on Determination of Long-Run Equilibrium under Perfect Competition in a Firm

In the long-run, every firm operating under perfect competition experiences no-profit-no-loss situation. If firms generate super-normal profit in the short-run, other firms will be allured by the prospect of that industry. In absence of any entry barrier (assumption), the firms willing to enter into that industry, will be able to do so easily.

This will increase number of firms in that industry. With the increase in number of firms, total supply will automatically increase implying that the total supply curve will shift towards right leading to a decline in price.

This continues till profit completely evaporates i.e., price equals average cost.

Image Source: utahaccidentbooks.com

If firms incur losses, some of them will close down being unable to tolerate losses. As a result, total supply in the market declines and consequently, supply curve shifts towards the left. This causes the equilibrium to move upward and price appreciates. This continues till price becomes equal to average cost.

Thus, in the long-run, firms arrive at a no-profit-no-loss situation. That is, they neither earn super-normal-profit nor do they incur any loss at the output level where both the profit maximising conditions are satisfied. This process is explained with the help of a diagram (see figure 10.6).

Let us start with a case of a profit-making firm. Left panel of figure 10.6 shows total demand and total supply curves of a product which are represented by DD and S₁S₁ respectively. Intersection of these two curves determine P₁ price.

The right panel of figure 10.6 shows what quantity an individual firm operating under perfect competition will produce for maximizing profit, given the product price. MC and AC represent this individual firm’s marginal and average costs respectively.

Since price line and MR curve are same for a firm under perfect competition, profit maximizing conditions are satisfied at point ‘b’. From this point, we obtain profit maximizing quantity of output as OQ₁ at OQ₁ output level, per unit cost is equal to Q₁c.

So, total cost incurred by this firm is equal to the area hcQ₁O, whereas total revenue generated by the firm is abQ₁O. Clearly, profit earned by the firm is equal to the area ‘abch’. This super-normal profit will allure potential entrants to enter into this industry.

Increase in number of firms causes a rightward shift of the total supply curve. This continues till the market supply curve shifts to S₃S₃. Intersection of S₃S₃ with the demand curve DD determines price OP₃. At this price, profit maximising output level of this firm becomes OQ₃.

At OQ₃ output level, per unit price (OP₃) and per unit cost (Q₃e) become equal. This implies that at OQ₃ output level, total revenue generated and total cost incurred by the firm are equal and this ensures attainment of no-profit-no- loss situation of a firm in the long-run.

Now, we take up the case where initially firms incur losses. Assume that the initial supply curve of the market is represented by S₂S₂. Intersection of DD and S₂S₂ determines OP₂ price. Given OP₂ price, the firm under consideration will produce OQ₂ Quantity of output.

At OQ₂ output level, per unit cost (Q₂m) exceeds per unit price (OP₂). Thus, total loss incurred by the firm is ‘jmkf. Being unable to tolerate losses, some firms will go out of this industry without any hurdle, because of non-existence of exit barriers.

Reduction in number of firms leads to leftward shift in market supply curve. This process containues till the market supply curve shifts to S₃S₃ which ensures attainment of no-profit-no-loss situation of the firm in the long-run.