By short run is meant a length of time which is not enough to change the level of fixed inputs or the number of firms in the industry but long enough to change the level of output by changing variable inputs.
In short period, a distinction is made of two types of costs (i) fixed cost and (ii) variable cost.
The fixed cost in the form of fixed factors i.e., plant, machinery, building, etc., does not vary with the change in the output of the firm. If the firm is to increase or decrease its output, the change only takes place in the quantity of variable resources such as labor, raw material, etc.
Further, in the short run, the demand curve facing the firm is horizontal. No new firms enter or leave the industry. The number of firms in the industry, therefore, remain the same. Under perfect competition, the firm takes the price of the product as determined in the market. The firm sells all its output at the prevailing market price. The firm, in other words, is a price taker.
Equilibrium of a Competitive Firm:
The short-run equilibrium of a firm can be easily explained with the help of marginal revenue = marginal cost approach or (MR = MC) rule.
Marginal revenue is the change in total revenue that occurs in response to a one unit change in the quantity sold. Marginal cost is the addition to total cost resulting from the additional of marginal unit.
Since price is given for the competitive firm, the average revenue curve of a price taker firm is identical to the marginal curve. Average revenue (AR) thus is equal to marginal revenue (MR) is equal to price (MR = AR = Price).
According to the marginal revenue and marginal cost approach or (MR = MC) rule , a price taker firm is in equilibrium at a point where marginal revenue (MR) or price is equal to marginal cost The point where MR = MC = Price, the firm produces the best level of output.
From this it may not be concluded that the perfectly competitive firm at the equilibrium level of output (MR = MC = Price) necessarily ensures maximum profit. The fact is that in the short run, a firm at the equilibrium level of output is faced with four types of product prices in the market which give rise to following results:
(i) A firm earns super normal profits.
(ii) A firm earns normal profits.
(iii) A firm incurs losses but does not close down.
(iv) A firm minimizes losses by shutting down. All these short run cases of profits or losses are explained with the help of diagrams.
Determination of Profit by Diagrams:
(1) Profit Maximizing Position of a Firm:
A firm in the short run earns abnormal profits when at the best level of output, the market price exceeds the short run average total cost (SATC). The short run profit maximizing position of a purely competitive firm is explained with the help of following diagram.
In the diagram (15.3), output is measured along OX axis and revenue or cost on OY axis. We assume here that the market price is equal to OP. A price taker firm has to sell its entire output at this prevailing market price i.e., OP. The firm is in equilibrium at point L. Where MC = MR. The inter section of MC and MR determine the quantity of the good the firm will produce.
After having determined the quantity, drop a vertical line down to the horizontal axis and see what the average total cost (ATC) is at that output level (point N). The competitive firm will produce ON quantity of output and sell at market price OP. The total revenue of the firm at the best level of output ON is equal to OPLN. Whereas the total cost of producing ON quantity of output is equal to OKMN. The firm is earning supernormal profits equal to the shaded rectangle KPLM. The per unit profit is indicated by the distance LM or PK.
It may here be noted that a firm would not produce more than ON units because producing another unit adds more to the cost than the firm would receive from the sale of the unit (MC > MR). The firm would not stop short of ON output because producing another unit adds more to the revenue than to cost (MR > MC). Hence, ON is the best level of output where profit of the firm is maximum.
(2) Zero Profit of a Firm:
A firm, in the short run, may be making zero economic profit or normal economic profit. It may here be remembered that although economic profit is zero, all the resources including entrepreneurs are being paid their opportunity. So they are getting a normal profit. The case of normal profits of a firms at break even price is explained with the help of the diagram 15.4.
We assume in the diagram (15.4) that OP is the prevailing market price and PK is the average revenue, marginal revenue curve. At point K, which is the break even price for a competitive firm, the MR, MC and ATC are all equal. The firm produces OM output and sells at market price OP. The total revenue of the firm to equal is the area OPKM. The total cost of producing OM output also equals the area OPKM. The firm is earning only normal profits. It is a situation in which the resources employed by the firm are earning just what they could earn in some other alternative occupations.
(3) Loss Minimizing Case:
The firm in the short run is minimizing losses if the market price is smaller than average total cost but larger than average variable cost. The loss minimizing position of a price taker firm is explained with the help of a diagram.
We assume in the diagram (15.5) that the market price is QP. The firm is in equilibrium at point N where MR = MC. The firm’s best level of output is OK which is sold at unit cost OP. The total revenue of the firm is equal to the area OPNK. The total cost of producing OK quantity of output is equal to OTSK. The firm is suffering a net loss equal to the shaded area PTSN.
The firm at price OP in the market is covering its full variable cost and a part of the fixed cost. The loss of part of fixed cost equal to the shaded area PTSN is less than, the firm would incur by closing down. In case of shut down, the firm has to bear the total fixed cost ETSF. The firm thus by producing OK output and selling at OP price is minimizing losses. Summing up, in the short run the firm will not go out of business for as long as the loss m staying the business is less than the loss from closing down.
(4) Short Run Shut Down:
The price taker firm in the short run minimizes losses by closing it down if the market price is less than average variable cost. The shut down position of a competitive firm is explained with the help of a diagram.
In this diagram (15.6), we assume that the market price is OP. The firm, is in equilibrium at point Z where MR = MC. The firm produces OK output and sells at OP unit cost. The total revenue of the firm is equal to the area OPZK. Whereas .the total cost producing OK output is OTFR. The firm is suffering a net loss of total fixed cost equal to the area PTFZ. The firm at point Z is just covering average variable costs.
If the price falls below Z, the competitive firm will minimize its losses by closing down. There is no level of output which the firm can produce and realize a loss smaller than its fixed costs. It is therefore a shut down point for the firm operate, when price is > average variable cost.