What is a Firm?  

Economic activity is related to the use of scarce resources of the economy that are used for producing goods and services which are required to satisfy various demands of the people. In other words, it can be said that it is all about satisfying the unlimited demands of individuals with the limited resources available. The production decision is taken by the producers or the firms. In economics, the terms ‘producers’, ‘suppliers’, and ‘firms’ are interchangeable. Now the question arises, what does a firm actually mean?  

A firm is typically (from the point of view of economics) an economic entity that uses factors of production or raw materials to produce goods or commodities that it (the firm) sells to others.   

A firm has two functions to perform in an economy.

1. A firm purchases factor services in a bulk from the households, and consequently utilizes them to produce goods and services.   
2. A firm converts inputs to outputs. Different firms that operate in an economy accumulate various factors of production such as labor and capital to create goods and services. Some firms produce goods or commodities while other firms are concerned with producing services. 

Meaning of Firm’s Equilibrium  

The word equilibrium means ‘state of rest’. It means that the forces which work in opposite directions are exactly in balance so that there exists no tendency to move in other directions.   

A firm is said to be in equilibrium or a stabilized condition when it selects a particular level of output at which it would like to stay at rest; there is no incentive for it to increase or decrease output from that level.    A firm stays in equilibrium when with given demand and cost conditions, it produces that level of output at which profit is maximized.  

Profit Maximization Objective  

In economics, it is believed that business firms always aim to maximize their profits (or minimize their losses). Though businessmen do indeed have other objectives like maximization of sales, maximization of firms’ growth rate, etc., according to economic theory, it is assumed that profit maximization is the only objective of the business firms to achieve. 

A firm is in equilibrium when it maximizes its profits. It is in equilibrium, from the point of view, that if the firm selects that level of output at which the profit is maximized, it would like to produce that level of output.  

Profits   

Profits possess the notion of the difference between the revenue that the firm earns from selling its output and the cost of producing that output. Symbolically;  

                              π  = TR-TC  

Where π resembles total profit, TR shows total revenue, TC shows total cost.  

When the difference between TR and TC is maximum, profit gets maximized. Thus, total profit depends upon total revenue and total cost. A profit-maximizing firm aims to produce that output and charge that price which maximizes the difference between TR and TC.  

Now there are different kinds of profits:   

In very brief, following are the types:  

• Normal profit: It is referred to as the amount of profit that will be enough for a firm to stay in the industry, and it will also be low enough to not let any new firm have a desire to enter the industry.   
•  Economic Profit: When TR exceeds TC, then a firm earns a supernormal profit or economic profit.  

Rule for Profit Maximization (Case: Perfect Competition)   

Now since it is known that what is equilibrium, now the question that arises is something like this: How does a firm arrive at maximum profits? What are the rules that must be followed by a firm to maximize its profits?  

Profit maximization rules are the same as rules of equilibrium of a firm because a firm maximizes its profit at the equilibrium level. There are two ways of understanding how a firm reaches its equilibrium level by maximizing profits:  

1. Total Revenue and the total cost approach (TR-TC approach).
2. Marginal Revenue and Marginal Cost approach (MR-MC approach). 

Total Revenue and Total Cost Approach  

This can be explained with help of total revenue and total cost curves. Since total profit is defined as the difference between TR and TC, profit will be optimal when the difference between TR and TC (TR-TC) is the maximum.  

 From the figure:  

The total revenue curve TR and total cost curve TC of the firm are shown in the figure. As output increases, TR goes on increasing at a constant rate. Thus, the TR curve is a straight line from the origin. The short-run TC curve starts from point A on the Y axis, which shows that the total cost is equal to the total fixed cost corresponding to a zero level of output. It is positively sloping which means that the cost and the output are directly related. It is concave downwards in the beginning and is concave upwards as it moves towards the right, this means that TC increases at decreasing rate at first and then at an increasing rate.   

It is very evident from the figure that up to OL level of output, TC curve lies above TR curve. This means that the firm is incurring losses to the extent of TC-TR. When the firm produces OL level of output, TR =TC, which means that the firm neither is making a profit nor does it incur any loss, the firm is now breaking even. Point B corresponding to OL output is called the break-even point. Beyond OL, TR>TC and the firm begins to earn profit till its output reaches ON. Beyond ON, however, TC overtakes TR and the firm starts incurring losses again. It means that the firm’s profitable range of output lies between OL and ON.   

How to find Profit-Maximizing Output?  

• One way to determine this is to find the output corresponding to which the difference between TR and TC curves is maximum. In the above figure, it has been shown that as the firm increases its output beyond OL, the profit is increasing up to the OM level of output. The vertical distance is widening at this point. At OM level of output, the distance between TR and TC curve is the greatest and, therefore, the profit will be maximum.   

• The second method of finding the profit-maximizing output is to directly draw the total profit curve which shows the difference between total revenue and total cost at various levels of output. In the above figure, the TP curve is a total profit curve which indicates the vertical distance between TC and TR curves at various levels of output. It is noticed that the TP curve first rises and then falls. Up to the OL level of output, the firm is making losses, and therefore, the TP curve lies below X-axis. In the same way, this will be the case beyond the ON level of output. At point L, the profit curve cuts the X-axis, showing that at the OL level of output, profit is equal to zero. As the firm increases its output beyond OL, the total profit curve TP rises, which indicates that the profit is increasing. Beyond OM level of output TP curve is negatively sloped, which means that the total profit is falling.   

Marginal Revenue and Marginal Cost Approach

In this approach, three conditions are needed to be fulfilled for the profit to be the maximum:  

1. A rule to decide whether or not to produce in the short run: It is known that a firm has to incur fixed costs in the short run even if it stops production altogether. These fixed costs are the reasons which explain why a firm sometimes continues to produce even if it is facing losses. If a firm exercises the option of shutting down and produces nothing, then the losses will be equal to the fixed costs. A profit-maximizing firm will never lose more than its fixed cost. When the price drops so low that the revenues become insufficient to pay the variable costs, then a firm completely stops the production process. But if the firm retains the capital, which would allow the firm to revive its production again in the future, then this situation is said to be known as shut-down. Therefore, when the firm decides whether to produce or not to produce, it has to compare the losses in the two situations- losses in a situation of shut down and losses when the firm continues to produce. This means that only when the price (P) or the average revenue (AR) covers at least the average variable cost (AVC), then only the losses in the production become equal to or less than the losses that are found in the case of shutting down. If P=AVC, it means that the firm is only covering the variable cost and is not being able to cover the fixed cost. In this case, losses in both situations - production or shut down- would be the same and would be equal to the fixed cost. But if P>AVC, then the firm would be able to cover the entire fixed cost and the variable cost.  

Therefore, rule no. 1 will be 'In the short run a firm should produce if and only if P or AR≥AVC or TR≥TVC'.

A rule that is necessary for profits to be the maximum: Now once the firm decides that it would be profitable to produce some output since rule 1 has been satisfied, and then the firm has to decide as to how much it should produce. Here, profit maximization output would be the one that equates marginal revenue with marginal cost.

Therefore, rule 2 will be : 'Profit maximizing output will be MR=MC'.  

Now the question arises why should profits be maximum at the level of output where MC=MR?  

If a firm finds that the cost of producing one more unit (MC) is less than the additional revenue (MR) that can be earned by selling that unit, it means that this additional unit produced adds to profits. Thus, if MR exceeds MC, then the firm can increase its profit by producing more. On the other hand, if the firm finds that the cost of producing another unit is more than the additional revenue that can be earned by selling that unit, that is, MR<MC, it means that if this additional unit is produced, then it will reduce the profit. Therefore, it follows that whenever the marginal cost is not equal to marginal revenue, the firm can increase its profit by producing more or less. But if MC=MR then it does not pay the producer to produce more or less.   

•  A rule to ensure that profits are maximized rather than minimized: Equality of marginal cost and marginal revenue is a necessary condition required for profit maximization.   

In the above figure, MC=MR at two levels of output, that is, OQ0 and OQ1. Output OQ0 is the minimum profit position. At the OQ0 level of output, the firm can cover its cost for the first time. R is, therefore, a break-even point. However, if the firm expands its output beyond OQ0, it will earn a profit, since MC<MR. Therefore, the firm will not stop producing output at the OQ0 level. It would be profitable for the firm to produce output up to the OQ1 level. Hence, point R cannot be the point of equilibrium. Output OQ1, on the other hand, is profit-maximizing output since a change in the output in either direction would reduce the profit. For the output which is just below OQ1, MC<MR and, therefore, profit can be increased by increasing the output towards OQ1. In the same way, at the output which is slightly above OQ1, MC>MR, and, therefore, the profit can be increased by reducing the output towards OQ1. Thus, point K, corresponding to the OQ1 level of output, is the point of equilibrium.  

Rule 3 can be said: MC Curve should cut MR curve from below.    

Context and Applications   

This topic is significant in the professional exams for both undergraduate and graduate courses, especially for 

• B.A.  Economics 
• M.A. Economics