SUPPLY
Major question to be answered by suppliers is “how much to produce”
In our analysis we are going to make assumptions.
a) All firms are price taking, in other words no single firm has the power to change the
prices in the industry.
b) Product homogeneity meaning there is no quality differences between products provided
by different firms.
c) Free entry and exit. There are no barriers to enter or exit from the markets.
d) Perfect information. Everybody has the perfect information about the prices, costs,
qualities etc…
If an industry satisfies all of those conditions, we call it perfectly competitive market.
Profit Maximization
Profit = Revenue – Cost
П = R –C
Revenue and costs depend on (functions of) quantity. Since perfectly competitive firms cannot
affect prices, price is not a choice variable for firms.
П(q) = R(q) –C(q)
In order to maximize profit, we differentiate it and make it equal to zero.
d dR dC


dq dq dq
0 = MR – MC
MR = MC Profit maximization condition (Remember marginal revenue (MR) is the
increase in the revenue of the firm when it produces one additional unit of output. )
Output Rule: If a firm is producing any output, it should produce at the level at which marginal
revenue equals marginal cost.
The demand faced by individual suppliers is different than market demand. For the whole
industry when the level of output changes the amount consumers are willing to pay changes as
well. Thus the demand for the whole industry is downward sloping. However, since an individual
firm makes up only small portion of the whole industry, the change in the production of it can
only slightly change the amount of output available to consumers. Thus individual firms cannot
change prices in the market thus face horizontal demand curves. (Remember when there is more
of something consumers are willing to pay less to purchase it.)
YTL
Market demand
Demand faced by
individual firms
Q
Since individual firms cannot affect the prices, if they increase their production by one unit, they
are going to be able to sell this last unit for the market price. So the revenue is going to rise by the
amount of price. In other words marginal revenue will be equal to price for perfectly competitive
markets. Since marginal revenue is constant (price), it also equals to average revenue.
YTL
Demand faced by
individual firms
P=MR=AR
Q
SHUT-DOWN DECISION IN THE SHORT RUN
When the price of the good is below average variable cost the firms will stop production and shut
down the production facilities. Continuing production will only increase negative profits.
However in the short run even if price is below average cost the firms continue production as
long as price is above average variable cost. The reason is in the short run fixed costs are sunk
and cannot be recovered, so by keeping production would lower the losses.
SHORT RUN SUPPLY CURVE
YTL
MC
AC
S
p1
AVC
p2
P3
Q
q
2
q
1
When the price is p1, this firm is going to equalize its MC and MR in order to maximize profits.
Remember MR is equal with price for competitive firms. Thus when the price is p1 this firm will
produce q1. Similarly when the price is p2, the firm will supply q2 units of output. However when
the price goes below AVC (such as p3), the firm stop production and shut down. Thus the short
run supply curve of a firm is above AVC section of MC curve.
SHORT RUN MARKET SUPPLY
In order to get the market supply curve we are going to horizontally sum the individual firms’
supply curves.
YTL
S1
S2
S3
Market
Supply
Q
LONG RUN SUPPLY CURVE
Long run competitive profit maximization for perfectly competitive markets occurs when long
run marginal cost(LRMC) equals to price(P) and also marginal revenue(MR).
P = LRMC = MR
SHUT-DOWN DECISION IN THE LONG RUN
The firms will continue production only if revenue equals or bigger than variable costs. However
since in the long run all costs are variable firms will shut down when the costs are bigger than
revenue.
Firm will shut down if
R<C
Because for competitive markets price equals with marginal revenue for the firms, shut down
decision rule can be expressed as
Firm will shut down if
MR=P <AC
Thus
LR firm supply is Marginal Cost Curve above the minimum of long run average cost curve.
YTL
MC
S
AC
p1
p2
P3
Q
q
2
q
1
When the price is p1, this firm is going to equalize its MC and MR in order to maximize profits.
Remember MR is equal with price for competitive firms. Thus when the price is p1 this firm will
produce q1. Similarly when the price is p2, the firm will supply q2 units of output. However when
the price goes below AC (such as p3), the firm stop production and shut down. Thus the long run
supply curve of a firm is above minimum point of AC section of MC curve.
LONG RUN MARKET SUPPLY
In order to get the market supply curve we are going to horizontally sum the individual firms’
supply curves. LR supply curve is different than SR supply curve for two reasons
1. Number of firms can vary in the long run.
2. Input prices vary in the long run.
LR market supply is horizontal if all three conditions hold
1. Free entry and exit.
2. Unlimited number of firms have identical cost structures.
3. Input prices are constant.
If one of those conditions does not hold the long run market supply curve would be upward
sloping. (In some cases if input prices decreasing with rise in output, the market supply curve can
be downward sloping)
Because when there is free entry and exit the profit opportunities will attract new investors to the
market until those opportunities are gone, the economic profits in the long run are zero.
Economic rent: The difference between the income earned by an input and the cost of the input.
(Opportunity cost) In other words economic rent is the amount paid to an input above the amount
necessary to induce the supplier to offer the input into the market. (Ex: Professional soccer
players, movie stars)