Wednesday, 2 March 2016

Definition and explanation of producer equilibrium in economics under different approaches

Just like the consumers indulge in maximising their satisfaction and utility levels by reaching towards consumer equilibrium, the producers also try to reach out to an equilibrium point of maximisation of their profits that is known as "producer equilibrium".

What is producer's equilibrium?
Producer's equilibrium is that point in the scale of production, at which point, the level of production of any particular commodity gives the maximum profit to the producer of that commodity. So, the total cost of production of that commodity will be much lesser than the total revenue obtained through sale of that commodity at that level. It is the maximum possible profit that any producer can obtain at that equilibrium point.

In other words, producer equilibrium refers either to the level of profit maximisation or otherwise, to the level of cost minimisation. Cost minimisation also results in profit maximisation.

Definition of producer equilibrium in economics

  • Producer's equilibrium can be defined as a state of economic condition that leads to achievement of that level of output after reaching which, no further maximisation of profit is possible.
  • It is that stage where there is no further inclination towards expansion or contraction of the output.
  • It is that point where there is maximum profitability and / or minimal loss.

Two approaches towards producer equilibrium

There are two approaches for reaching out to producer's equilibrium:
1) the TR - TC approach and
2) the MR = MC approach.

There can be two types of markets for studying producer equilibrium

a) Perfect competition market where prices remain constant and
b) Imperfect competition market where prices are either raising or falling constantly.
We need to study the equilibrium under both these conditions of the markets.

Now, let us study producer's equilibrium under all these different conditions, one by one.

I) Total Revenue - Total Cost (TR - TC) approach

Under TR - TC approach, the producer tries to attain equilibrium point by maximising his profits to the utmost possible level. So, this implies that the TR-TC approach should satisfy two conditions.

  • The difference between Total Revenue and Total Cost has been maximised.
  • Any further effort to increase output after that point will result in a fall of the total profit.

Let me explain this under both circumstances of perfect competition and Imperfect competition.

i) The producer equilibrium under perfect competition (When prices remain constant)
When prices are constant in perfect competition, producer goes on increasing output or sales and is able to enjoy maximum profit till a certain point after which, he may not be able to produce more without adding extra machinery or extra expenses and capital. So, addition of capital and machinery may result in increased costs of the product. Or, otherwise, he may not be able to sell more unless he decreases the price, which also may result in decrease of profits.

Let us study it through a table as below.

Price per unit       Output (units)      Total Revenue     Total Cost     Profit

      6                        1                          6                      5                  1
      6                        2                        12                     10                 2
      6                        4                        24                     19                 5
      6                        6                        36                     28                 8
      6                        7                        42                     34                 8
      6                        8                        48                     41                 7

From the above illustration, we can see that producer equilibrium has been achieved at the output level of 7 units, at which point you are able to maintain the maximum profit of 8 dollars by producing maximum output of 7 units. When you tried to increase the output by another unit, the profit decreased to 7 dollars.

The same thing can be illustrated in the form of a graph also.

ii) Now, watch producer equilibrium under imperfect competition (when prices are falling upon increased output )
There is no control over prices, and each producer has his own price fixation norms and sells products accordingly. But, after a certain level of output, he gets forced to lower the prices as he has got excess stocks of output. The below example illustrates this position.

Price per unit       Output (units)      Total Revenue     Total Cost      Profit
       8                       2                          16                    10                   6
       7                       3                          21                    14                   7
       6                       5                          30                    21                   9              
       5                       6                          30                    23                   7

The producer equilibrium in the above example is attained at output level of 5 units. After that level, additional output of another unit resulted in fall of total profit.

II) Marginal Revenue = Marginal Cost Approach (MR = MC approach)

According to this approach, producer equilibrium is attained where the marginal revenue of additional output equals its marginal cost.

This approach should satisfy the following two conditions or assumptions:
1) MC = MR
2) Marginal cost becomes higher than Marginal Revenue if one more addition to output takes place after reaching the output level of MR = MC

Let us study this approach also under both the perfect and imperfect competition conditions of the market.

i) Producer equilibrium under perfect competition (when price is constant)
When price is constant, each unit of output is sold at the same price. So, the average price (AR) of any particular unit is same for each and every unit. The marginal revenue (MR) will be same as the AR and the marginal revenue (MR) also will be same as AR for each unit. So, you will enjoy the producer equilibrium until there is any rise in MC or fall in MR.

Let me illustrate this with a table as below.

Price (Rs.)    No.of units         TR            TC              MR            MC          Profit (TR-TC)
6                    1                     6                8                6                 8                -2
6                    2                    12              15                6                 7                -3
6                    3                    18              20                6                 5                -2
6                    4                    24              24                6                 4                 0
6                    5                    30              28                6                 4                 2
6                    6                    36              34                6                 6                 2
6                    7                    42              41                6                 7                 1

From the above, we can see that the producer was incurring losses initially and he went on increasing his output to nullify the losses and make profits. When he produced 4 units, there were no losses. At the level of 5 units production and 6 units production, he was able to make profits of 2 points. At the level of 6 units production, the MR is equal to MC. When he tried to increase output by one more unit, the profit decreased again. So, the producer equilibrium output is 6 units in this case.

ii) Producer equilibrium under imperfect competition (when price falls with increase in output)
When there is no perfect competition among sellers, the producers and sellers try to maximise their profits, by indulging in unhealthy practices. They take advantage of some monopolistic circumstances and charge very high prices to gain maximum profits. This is workable until certain stage. But when the quantity produced becomes too much with alternative identical products coming into the market, demand gets distributed among identical products and naturally each brand of product loses its demand in the long run. The effect will be fall in prices of products. So, too much increase in production will result in fall of prices. In such circumstances, the producer has to decide upon his maximum level of production based on producer equilibrium. He will try to match Marginal Cost with Marginal Revenue in deciding his level of production.

Let us consider an example to arrive at this producer equilibrium under changing prices of market.

Qty. produced   Price per unit           Total              Total       MR      MC      Profit 
                                                     Revenue           Cost                             (TR-TC)
           1                    8                        8                   6           8        6            2
           2                    7                       14                 11           6        5            3
           3                    6                       18                 15           4        4            3
           4                    5                       20                 18           2        3            2

In the above illustration, it is noticed that MR and MC are both equal to one another at the level of 3 units production. After that level, when production is increased to 4 units, the profit began decreasing as MC is higher than MR at that point. So, producer equilibrium level of output is 3 units in this case.   

From the above study of producer equilibrium, we are able to notice two salient features.
1) Under perfect competition (where prices remain constant), Price = MR = MC, ie. the product price, marginal revenue and marginal cost equal to one another at the equilibrium point.
2) Under imperfect competition (where prices fall with every increase in supply or production), Price is always greater than MC or MR as equilibrium is attained at a point of MC=MR and marginal revenue will be always decreasing with additions of supply.                  

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