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Micro Economics

Notes Figure 10.2(b) shows the seller perceived demand curve which is horizontal, i.e., it is perfectly
elastic demand with respect to price. It hits the vertical axis at the current market price, P. Two
factors are stopping the producer from charging a price such as P , which is higher than P-perfect
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knowledge and homogeneous product. If a higher price is charged, customers would know
immediately that a lower price is available elsewhere, and that the product for sale at the lower
price is a perfect substitute for the more expensive product. The producer is also not undercutting
its rivals and charging a price, P which is lower than P. The fi rm’s output is small compared to
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the industry as a whole and so its entire output can be sold at the current market price of P. At

a price lower than P the firm would not maximise its profit. Thus, over any feasible range of

output, the demand curve for the product of the individual firm is perceived to be horizontal.

Notes Equilibrium of the Firm
Firms aim to maximise profit and they can be in equilibrium only when they achieve

this. For all fi rms, profit maximisation is achieved when Marginal Revenue (MR), equals

Marginal Cost (MC). If MR>MC, the firm adds more to revenue than it does to costs by

increasing output and sales. When this happens profits will rise. On the other hand, if

MR<MC, the firm adds more to costs than it does to revenue by expanding output and

sales. When this happens profits will fall. It follows thus, that the firm is in equilibrium

when MC=MR.
Equilibrium of the Industry
The industry is in long run equilibrium when a price is reached at which all firms are in

equilibrium (producing at the minimum point of their LAC curve and making just normal

profits). Under these conditions, there is no further entry or exit of firms in the industry,

given the technology and factor prices. At the market price P, the firms produce at their

minimum cost, earning just normal profi ts. The firm is in equilibrium because at the level
of output Q
LMC = SMC= P = MR
This equality ensures that the firm maximises its profi t.

At the price P, the industry is in equilibrium because profits are normal and all costs are
covered so that there are no incentives for entry or exit.
10.2 Short Run Equilibrium of a Perfectly Competitive Firm

The aim of a firm is to maximise profits. In the short run some inputs are fixed and these give rise

to fixed costs which have to be incurred whether the firm produces or not. Thus, it pays for the

firm to stay in business in the short run even if it incurs losses. Thus, the best level of output of the

firm in the short run is the one at which the firm maximises profits or minimises losses.

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