Q26 — Perfect Competition: Equilibrium of Firm and Industry (Short Run & Long Run)

Introduction

The concept of perfect competition occupies a central place in traditional microeconomic theory. It provides a clear and rigorous benchmark for analysing how prices and output are determined by the interaction of market demand and market supply, and how individual firms behave when they are price-takers. In your prescribed book “Microeconomics” by T.R. Jain & V.K. Ohri for B.Com (Sem I), Panjab University, the equilibrium of a firm and the industry under perfect competition is analysed separately for the short run and the long run.

A complete answer must therefore: (i) define perfect competition and state its main features; (ii) explain the short-run equilibrium of a competitive firm (and show cases of supernormal profit, normal profit and loss); (iii) explain the short-run equilibrium of the industry; and (iv) explain long-run equilibrium of firm and industry under perfect competition with suitable diagrams and clear conditions.

I. Meaning and Essential Features of Perfect Competition

1. Meaning

Perfect competition is a market structure in which a large number of buyers and sellers deal in a homogeneous product, and no individual buyer or seller is able to influence the price. The price of the commodity is determined by the forces of demand and supply at the industry level, and each firm is a price-taker.

Definition (exam-style):
Perfect competition is a form of market in which there are a very large number of sellers and buyers of a homogeneous product, each firm is too small relative to the market to influence price individually, and price is determined by the industry through the interaction of market demand and market supply. The individual firm only chooses the quantity to produce at the given market price.

2. Essential Features of Perfect Competition

Large number of buyers and sellers: The number of firms is so large that each firm supplies only a negligible fraction of total market output. No single firm can influence the market price.
Homogeneous product: All firms sell identical (homogeneous) units of the product. There is no product differentiation. As a result, buyers are indifferent regarding the source of supply.
Free entry and exit of firms: In the long run, there are no artificial legal or natural barriers to entry or exit. Firms are free to enter the industry when they expect profits and free to leave when they incur losses.
Perfect knowledge: Buyers and sellers possess complete knowledge about market conditions— prices, quality and availability. Hence no firm can charge a price higher than the ruling market price.
Perfect mobility of factors: Factors of production can move freely from one occupation or region to another. This ensures uniformity of factor prices and facilitates entry or exit of firms.
Absence of transport cost (or equal transport costs): For simplicity, it is assumed that either there is no transport cost or it is the same for all firms, so it does not create any price difference.
No selling costs: Since products are homogeneous and buyers have perfect knowledge, firms do not need to incur selling costs like advertising to attract customers.
Price-taker firm: The individual firm takes price as given. Its own demand curve is perfectly elastic at the ruling market price.

These assumptions collectively ensure that the individual firm under perfect competition has a horizontal AR and MR curve at the level of market price.

II. Short-run Equilibrium of a Firm under Perfect Competition

1. Concept of Equilibrium of a Firm

A firm is in equilibrium when it has no tendency either to expand or to contract its level of output, i.e. when its profit is maximised (or loss is minimised). In traditional microeconomic theory, the profit-maximising condition is:

MR = MC and MC cuts MR from below.

Under perfect competition, since price is constant for the firm, we have:

P = AR = MR

Therefore, the equilibrium condition of a competitive firm becomes:

Equilibrium condition (short run):
The firm is in equilibrium at the level of output where P = MC (i.e. AR = MR = MC) and the MC curve cuts the AR = MR line from below.

2. Diagram: Short-run Equilibrium of a Competitive Firm

Fig. 1 — Short-run equilibrium of a perfectly competitive firm: AR = MR = P is a horizontal line; MC cuts it from below at point E and determines equilibrium output Q*. The position of AC relative to AR determines whether the firm earns supernormal profits, normal profits or losses.

3. Possible Profit Situations in the Short Run

Depending on the position of the short-run average cost (SAC or AC) curve relative to the AR = MR line, three cases arise:

Supernormal (abnormal) profits:
If at equilibrium output Q*, the AR = P line lies above the AC curve (P > AC), the firm earns supernormal profit equal to (P − AC) × Q*. This is possible in the short run because entry of new firms is not instantaneous.
Normal profits:
If at Q*, the AR line is tangent to the AC curve (P = AC), the firm earns only normal profit. Normal profit is treated as part of cost (the minimum return necessary to keep the entrepreneur in the business).
Loss (sub-normal profit):
If at Q*, the AR line lies below the AC curve (P < AC) but is still above the AVC curve, the firm incurs losses in the short run but continues production because it covers all variable costs and a part of fixed cost. Shutdown occurs only when price falls below minimum AVC.

Shutdown rule (short run):
A competitive firm continues to produce in the short run as long as price (P) is at least equal to minimum AVC. If P < minimum AVC, the firm minimises its loss by shutting down and bearing only fixed costs.

III. Short-run Equilibrium of Industry under Perfect Competition

An industry is a group of firms producing a homogeneous product. Short-run equilibrium of the industry is determined by the intersection of market demand and market supply.

1. Determination of Market Price

The market demand curve for the product is downward sloping, showing an inverse relation between price and quantity demanded.
The market supply curve is obtained by horizontal summation of individual firms’ marginal cost curves above their respective minimum AVC.
The intersection of demand and supply curves determines the short-run equilibrium price (P₀) and total quantity supplied by the industry.
At this price, each firm behaves as a price-taker and adjusts its output so that MC = P₀.

Fig. 2 — Short-run equilibrium of industry and firm under perfect competition: industry equilibrium price P₀ is determined by market demand and supply; each firm takes P₀ as given and chooses its own equilibrium output where MC = P₀.

At the industry level, equilibrium is achieved when quantity demanded equals quantity supplied. At the firm level, each competitive firm produces that quantity at which its MC curve intersects the horizontal price line. The number of firms in the industry is given by dividing industry output (Q₀) by the average output per firm (q₀).

IV. Long-run Equilibrium of Firm and Industry under Perfect Competition

In the long run, all factors of production are variable. Firms are free to enter or exit the industry. Therefore, supernormal profits or losses in the short run are only temporary. Long-run equilibrium under perfect competition is characterised by zero supernormal profit, i.e. each firm earns only normal profit.

1. Adjustment from Short Run to Long Run

If firms are earning supernormal profits in the short run (P > AC), this attracts new firms into the industry in the long run. Industry supply increases, shifting the supply curve to the right and causing the market price to fall.
If firms are incurring losses in the short run (P < AC), some firms exit the industry in the long run. Industry supply decreases, shifting the supply curve to the left and causing the market price to rise.
Entry and exit continue till all firms earn only normal profit (P = minimum LAC), and no firm has any incentive to either enter or leave the industry.

2. Long-run Equilibrium Conditions for a Competitive Firm

For a perfectly competitive firm in long-run equilibrium, the following conditions must hold simultaneously:

Profit maximisation: MR = MC (as always).
Zero supernormal profit: P = AR = minimum LAC (only normal profit is earned).
MC intersects LAC at its minimum point: MC = LAC at the minimum point of LAC.

Since under perfect competition P = AR = MR, the long-run equilibrium implies:

Long-run equilibrium (firm):
P = AR = MR = LMC = minimum LAC

3. Diagram: Long-run Equilibrium of a Competitive Firm

_LR E_LR

Fig. 3 — Long-run equilibrium of a perfectly competitive firm: price line is tangent to LAC at its minimum point, and LMC intersects LAC at the same point. The firm earns only normal profit.

In the above figure:

The price line P = AR = MR is horizontal and is tangent to LAC at its minimum point.
LMC cuts LAC at its minimum point and also intersects the price line at the same point.
The corresponding output Q_LR is the firm’s long-run equilibrium output.
At this point, the firm earns zero supernormal profit (P = LAC), so there is no incentive for new firms to enter or existing firms to leave the industry.

4. Long-run Equilibrium of the Industry

At the industry level, long-run equilibrium under perfect competition is attained when:

The number of firms in the industry is such that the industry supply curve intersects the market demand curve at a price equal to minimum LAC of each firm.
All firms earn only normal profit and there is no tendency for firms to enter or exit.
The industry operates at a scale where, given technology and factor prices, production is most efficient.

In a constant-cost industry (assumed at this level unless otherwise stated), long-run supply is typically horizontal at the level of minimum LAC. In increasing or decreasing cost industries, the long-run supply curve slopes upward or downward respectively, but the fundamental feature of long-run competitive equilibrium remains: P = minimum LAC for each firm.

V. Summary: Short-run vs Long-run Equilibrium under Perfect Competition

Short-run equilibrium:

Some factors are fixed; number of firms is given.
Firm’s equilibrium condition: MR = MC and MC cuts MR from below.
Firms may earn supernormal profits, normal profits or losses.
Industry equilibrium: market demand = market supply at equilibrium price, which is taken as given by each firm.

Long-run equilibrium:

All factors are variable; free entry and exit of firms.
Firms adjust their scale of plant; inefficient firms exit, new firms may enter.
Equilibrium conditions: P = MR = MC = minimum LAC (normal profit only).
No firm has any tendency to change its output or plant size; no firm has incentive to enter or leave the industry.

VI. Importance and Examination Relevance

The analysis of perfect competition and equilibrium of firm and industry is important for several reasons:

It provides a clear benchmark of efficiency where price equals marginal cost and minimum long-run average cost.
It helps in understanding how market forces of demand and supply operate in the absence of monopoly power and imperfections.
It serves as a standard of comparison when analysing imperfect markets such as monopoly and monopolistic competition (taken up in later questions).
For Panjab University B.Com (Sem I), this question is a core 15-marks theory question. A well-structured answer with clear definitions, step-wise explanation of short-run and long-run equilibrium, and neat diagrams for firm and industry is highly scoring and aligns closely with the treatment in T.R. Jain & V.K. Ohri.

Exam Tip (for full 15 marks): Write your answer in this sequence: (i) precise definition and features of perfect competition; (ii) short-run equilibrium of firm (conditions, diagram, three profit cases); (iii) short-run equilibrium of industry with separate panel for market and firm; (iv) long-run equilibrium of firm (conditions P = MR = MC = minimum LAC, diagram) and industry (entry–exit and normal profit); and (v) a brief concluding paragraph. Label all curves and equilibrium points clearly in diagrams as Panjab University examiners give special credit for neat and well-labelled figures.

These notes form part of a carefully curated set of important questions which have frequently appeared in past university examinations and therefore carry a high probability of being reflected, in whole or in part, in future question papers. However, they are intended as high-quality academic support material only and should not be treated as a guarantee or assurance of any specific questions being asked in forthcoming exams.