Equilibrium of the Firm

Equilibrium of the Firm Under Different Market Conditions (Price-Output Determination):

Under Perfect Condition: We know a firm under perfect condition faces a horizontal demand curve where price = AR = MC.

A firm under perfect competition earns only normal profit. But, in the short-run, a firm may earn abnormal profit. The abnormal profit is said to exist when MR is greater than the short-run average cost (SAC). Graph

Price Output Determination under Monopoly: We know a monopoly firm faces a downward sloping demand curve or average revenue curve (AR) curve. That is a monopoly firm can increase sale by reducing the price. A monopoly firm is likely to earn abnormal profit.

Monopoly equilibrium and Competitive equilibrium compared: The similarity is that under both market conditions a firm is in equilibrium (maximum profit) when marginal revenue (MR) equals marginal cost (MC).

Differences: There are several differences between a firm under perfect competition and a monopoly firm at the equilibrium point. These are:

 Price Discrimination: A monopolist firm is usually blamed for exercising price discrimination. Price discrimination means charging different prices for the same product from different people. According to Robbins, price discrimination is “charging different price for the same product, same price for the differentiated product.” The product may be differentiated by time, appearance or place. Stigler defines price discrimination “as the sale of various products at prices which are not proportional to their marginal costs.”

Price discrimination may be personal (charging different prices from different persons), local (charging different prices at different locations, or according to trade or use (charging different prices for business-use or for household consumption).

Equilibrium of the Firm in a Factor Market: By Equilibrium in the factor market means the maximum number of a factor the firm uses with minimum possible costs. The maximum number of a factors (or a combination of factors) used with minimum possible costs also means that a firm reaches the maximum profit position. To reach the equilibrium position, a firm must fulfill certain conditions.

Conditions of General Equilibrium in a Factor Market: The conditions are: 1. The Marginal Revenue Productivity (MRP) should be equal to the Marginal Factor Cost (MFC) or the remuneration of a marginal factor. 2. The MRP curve must cut the MFC curve from above.

Wages: The term wages means payments made for the services of labor. According to Benham wages mean “ a sum of money paid under contract by an employer to a worker for services rendered.

Nominal Wages: Are money wages paid to workers.

Real Wages: Are the purchasing powers a worker receives for the services rendered.

Theories of wages: Subsistence Theory, Wages fund Theory, Residual Claimant Theory, Marginal Productivity Theory, Modern Theory (Demand and Supply)

Subsistence Theory: According to this theory, wages tend to settle at a level just sufficient to maintain the worker and his/her family at subsistence level.

Wages Fund Theory: According this theory, wages depend upon two quantities:

1. The wages fund or the circulating capital set aside for the purchase of labor.

2. The number of workers seeking employment.

If the number of workers seeking employment is low, the wage per head will be high and vice versa. Or if the wages fund is smaller, the wage per head is lower and vice versa.

Residual Claimant Theory: According to this theory, wages are residue left over, after the other factors of production have been paid. According to this theory, rent and interest are governed by contracts, and profit is determined by definite principles. But there are no principles operating with regard to wage. So, after rent, interest, and profit have been paid, the reminder goes to the workers as wages. 

Reasons for Differences in Wages

Rent: Rent is payment made for the use of land. Ricardo defined rent as “the portion of the produce of earth which is paid to the landlord for the original and indestructible power of soil”. According to Ricardo, rent arises due to differences in surplus accruing to the cultivators and resulting from the differences in fertility of soil of different grades of land.

Ricardian Theory of Rent: Ricardian theory of rent is based on the principles of demand and supply. If supply of land in a country exceeds the total demand for land, no rent will be paid, like nothing is paid for the use of air. According to Ricardo, “If all lands had same properties, if it were unlimited in quantity, and uniform in quality, no charge could be made for its use, unless where it possessed peculiar advantages of situation.” Rent is chargeable – because land is not unlimited in quantity and uniform in quality and because (due to increase in population) land of inferior quality, or less advantageously situated, is called into cultivation. Ricardo has shown that rent arises in both extensive and intensive cultivation of land.

Extensive Cultivation: It means extending cultivation to different grades of land with same amount of capital and labor applied to all grades of land. When land is cultivated extensively, rent on superior land equals the excess of its produce over that of the most inferior land.

Intensive Cultivation: It means putting more and more of labor and capital on the use of land. For example, before land ‘B’ is brought under cultivation, additional capital is employed more productively on land ‘A’. But it is quite likely that doubling the amount of capital would not double the output.

Transfer Earning and Economic Rent: Transfer Earning: It is also called opportunity cost and “Reservation Price”. Assuming that a factor has alternative uses, transfer earning has been defined as the amount a factor must earn to remain in its present occupation. It is the minimum amount that must be paid to a factor to avail of its services. Alternatively, the transfer earning can be defined as the amount that a factor expects to earn if transferred to its second best use.

Economic Rent: It is the excess of actual earning of a factor over its transfer earning.

Interest Interest is the amount paid to the owner for the use of the services of capital. The lender charges an extra amount form the borrower of capital for the services used – it is called interest.

Theories of Interest

Bohm-Bawerk/s Theory of Interest: According to Bohm-Bawerk, “interest is paid in the process of lending present income against the promise of future income”. Interest arises because people prefer present consumption of goods to their future consumption. It is discount for future goods. Bohm-Bawerk gave three reasons why people prefer present consumption to future.

1. The circumstances of wants and provision for the present wants and future wants are different.

2. People underestimate future because of (a) deficiency of imagination, (b) limited will power, and (c) the shortness and uncertainty of life.

3. Present goods are economically superior to future ones. (money in hand today is more than the money in hand tomorrow).

Fisher’s Liquidity Preference Theory: Fisher’s notion of interest is the same as that of Bohm-Bawerk. According to Fisher, interest arises because people prefer present to future income. The rate of interest equals the price that people are willing to pay for income now rather than income at some future date. The price (interest) is determined by the interaction of “willingness to give up present consumption in favor of a larger consumption in future, and opportunity to invest”.

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