Total Revenue-Total Cost Approach

A firm is said to be in equilibrium when it is earning maximum profits. A firm will go on increasing its output if its profits are thereby increasing. It will fix output at the level where it is making maximum profits. Profits are the difference between total revenue and total cost (TC). Thus, the firm will be in equilibrium at the level of output where the difference between total revenue and total cost is the largest. Figure (1.1) portrays what is called break-even chart by businessmen. Total revenue curve (TR) starts from the origin because when no output is produced by firm revenue is zero. Total revenue goes on increasing as more output is produced. Total cost curve TC starts from a point F which lies above the origin the reason behind is that even when there is no production the firm has to incur some costs equal to OF. For example, when the firm has to stop production in the short run, it has to bear the fixed costs. Fig.(1.1) depicts short-run TR and TC curves of the firm. As a firm starts from zero increase in output increases TR &TC. But, in the initial stage TC is greater than TR and the firm is not making any profits at all. When firm is producing OX1, level of output, TR is just equal to TC and the firm is making neither profits nor losses, that is, the firm is only breaking even. Thus the point –S or output X1 is called break-even point.
When the firm increases its output beyond OX1, TR becomes larger than TC and profits begin to accrue to the firm. It will be seen from figure that profit is rising as the firm increases production to Ox2since the distance between the TR and TC has been widening. At OX2 level of output, the distance between TR and TC is the largest and therefore profit will be maximized. Thus the equilibrium level of output is OX2. The firm will not produce any output larger than OX2 because after this the gap between TR and TC curves goes on narrowing down and the total profits will be declining. At OX3 level of output TR and TC curves again intersect each other, which means that TR =TC at output OX3. This point H (i.e. output OX3) is again break-even point. Beyond output OX3, TR is less than TC and the firm will make losses if it produces any output larger than OX3.
Another way to find out the profit maximizing output is to draw directly total profit curve showing the difference between TR and TC at various levels of output. It will be seen from figure that TP lies below the X-axis up to output X1 that is firm is making losses (negative profits) and at X1 the profit curve the X-axis indicating profits are equal to zero. As the firm increases its output beyond OX1, TP is rising which indicates that total profits are increasing. At output OX2, profit curve stands highest from the X-axis and beyond OX2 the profit curve slope downward indicating that TP are declining. Therefore at OX2 output the firm will be making maximum profits and hence will be in equilibrium position.