Producer’s Equilibrium

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Equilibrium is that state of rest where no change is required. When spoken in terms of producer’s equilibrium, it means that any firm or company that produces a product or service has reached a level of output where it does not wish to either expand or contract it. This producer’s equilibrium state could be of maximum profit or minimum losses.


What is Profit? 

To define a producer’s equilibrium, one must first understand the concept of profit in business. A producer is a creator of any utility, by converting inputs to outputs. Profit is the amount received by the producer on the sale of goods which exceeds the amount spent on producing the goods. Whenever you produce any good, you incur some amount that reflects the money spent on labour, raw materials, etc. This is termed as “cost”. By selling the goods, you receive some amount which is termed as “revenue”. The difference between revenue and cost is what you define as profit.


Define Producer’s Equilibrium

In any business, the producer wants to maximize his satisfaction which comes with more profit. The producer must reach a level of output where his profits are maximized. By having an optimal combination of factors, a producer can reach a producer’s equilibrium if his profits are maximum. The producer’s equilibrium is also referred to as profit maximization condition. To reach this state of equilibrium, the following 2 things have to be achieved.

  • Costs are minimized for a given level of output.

  • Outputs are maximized for a given amount of cost.


Consumer and Producer Equilibrium 

The consumer and producer equilibrium are different from each other as outlined below.

  • A consumer’s equilibrium refers to the point where he or she derives maximum satisfaction by spending money on the consumption of goods and services.

  • A producer’s equilibrium refers to the state where the combination of price and output gives maximum profit to the producer. By producing any more goods than the equilibrium state, the producer’s profit would begin to decline.


Methods of Determining Producer’s Equilibrium 

There are mainly 2 methods utilized in determining the producer’s equilibrium for any firm.


1. TR - TC Approach - This is the total revenue total cost approach. The producer equilibrium formula in this is based on the difference between TR and TC. The equilibrium happens when TR minus TC is positive and maximum. Beyond this point, the producer has no incentive to either increase or decrease the output. In case the producer increases his output, the profits would start falling. Hence the 2 important conditions to be met under this approach are as follows.

  1. TR-TC is positively maximized.

  2. Profits fall after this level of output.

Two situations can arise in this case.

  • Price remains constant - This happens in a perfect competition where price remains the same at all levels of output. We will explain this with the following example.


Output Units

Price

TR

TC

Profit - TR-TC

0

12

0

5

-5

1

12

12

13

1

2

12

15

18

3

3

12

20

30

10

4

12

30

40

10

5

12

40

32

8

6

12

45

40

5


In the table above we can mark that profit rises first and then becomes a maximum at Rs.10 with 3 and 4 units produced. After that, profit begins to decline. Hence, in this case, the maximum profit is reached at 3 or 4 units of production. However, the producer’s equilibrium would be said to reach at 4 units of production because both conditions stated above (TR-TC is maximum and profits fall after this point) should be met.

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  • Price falls when output is increased - In imperfect competition, prices might fall when output increases. We will explain this with the following example.


Output Units

Price

TR

TC

Profit - TR-TC

0

12

0

5

-5

1

9

9

5

4

2

8

16

9

7

3

7

21

11

10

4

6

24

14

10

5

5

25

20

5

6

4

24

27

-3


Here initially with price coming down, profit goes up and is maximum at 3 and 4 units. After this, the profit starts declining. So fulfilling both conditions of Producer’s equilibrium, we get it at 4 units of output.

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2. MR - MC Approach - This is the marginal revenue and marginal cost approach. The producer’s equilibrium formula for this approach is given by the following 2 fundamentals.

  1. MR = MC. So till the point, MC is less than MR, the producer would keep producing till she or he hits the level of equal MR and MC. 

  2. MC > MR after the MC = MR output level is reached. MC = MR is not a sufficient condition to reach the producer’s equilibrium. For any additional unit of production, MC must exceed MR to realize the producer’s equilibrium for output level.

Here, MR is an additional amount earned over and above TR (total revenue) when more than 1 unit of product is sold. MC is an additional cost incurred over and above TC when more than 1 unit of product is produced. We will now examine this approach with the following 2 situations.

  • When price remains constant - When the price is fixed, firms can sell any amount of product. In this case, revenue from each additional unit, i.e., MR is equal to AR or the price. AR and MR curves would be the same in this scenario. So this would mean that price is equal to MC at all levels of output. Producers would aim to produce to a point where MC = MR and MC > MR after it reaches MC = MR output level. You can see this clearly in the image below:

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  • When the price falls with output increase - The MR curve would slope downward if there is no fixed price and there is a fall in price when output increases. In this case, producers would aim to produce to a level where MC = MR and MC curve cuts the MR curve from below. This is depicted in the below producer equilibrium graphical presentation.

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FAQ (Frequently Asked Questions)

Q1. What is an Isoquant Curve? Explain Producer Equilibrium with Isoquant Curve.

Answer: Isoquant curves demonstrate the different input combinations that produce the same level of output. The producer can select any of these combinations since the output is the same in all the cases. Isoquant curves are also called equal-product curves. Their key features are:

  • They have negative slopes.

  • Convex in shape.

  • They never intersect. 

  • The curves on the right denote more output and curves on the left denote lesser outputs.

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In the graph above IQ1, IQ2, IQ3, and IQ4 are the different isoquant curves.

Q2: What is the Isocost Line? Depict this with Producer Equilibrium Graphical Presentation.

Answer: Also termed as budget lines or budget constraint lines, isocost lines represent a combination of 2 money spending factors that will maximize the output. These various combinations of 2 factors are labour and capital. A firm can decide to purchase on any combination given the total outlay or the money at disposal. A combination of isoquant curves and isocost lines gives us the producer’s equilibrium. We can represent the isocost line mathematically as follows.

C = (w * L) + (r * K)

Here C - the cost of production

w - the cost of labour wages

L - units of labour

r - the price of capital or interest rate

K - units of capital

Any combination of these can be selected which satisfies the above equation, for example, “30 units of labour + 20 units of capital”. We can see this isocost line graphically below:

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Q3: What are Exceptions to the Normal Isoquant Curves?

Answer: There are 2 exceptions to the normal shape of the isoquant curve and these are as follows.


1. Linear Isoquant - When 2 factors perfectly substitute each other, then we get a linear isoquant curve rather than its usual convex shape. The marginal rate of any technical substitution for both the factors remains constant. If there is any addition in one factor, then there is a reduction of an equal amount in the other factor.


2. L-shaped Isoquants - We get an L-shaped or right-angled isoquant when 2 factors complement each other perfectly. Let us say the 2 factors are labour and capital. If they perfectly complement each other, then the producer can increase both of them proportionally to increase the output. If the producer changes one factor without changing the other, then there will be no change in the output.