The Competitive Firms Short Run Supply Curve

A supply curve for a firm tells us how much output it will produce at every possible price. We have seen that competitive firms will increase output to the point at which price is equal to marginal cost, but they will shut down if price is below average variable cost. Therefore, for positive output the firm's supply curve is the portion of the marginal cost curve that lies above the average variable cost curve. Since the marginal cost curve cuts the average variable cost curve at its minimum point (recall our discussion in Chapter 7 of marginal and average cost), the firm's supply curve is its marginal cost curve above the point of minimum average variable cost. For any P greater than minimum AVC, the profit-maximizing output can be read directly from the graph. At a price PI in Figure 8.5, for example, the quantity supplied will be qi, and at Pi it will be q2. For' P less than (or equal to) minimum AVC, the profit-maximizing out-

FIGURE 8.5 The Short-Run Supply Curve of a Competitive Firm. In the short run, the firm chooses its output so that marginal cost MC is equal to price, so long as it covers its variable cost of production. The short-run supply curve is given by the cross-hatched portion of the marginal cost curve.

put is equal to zero. In Figure 8.5 the entire supply curve is the cross-hatched portion of the vertical axis and the marginal cost curve.

Short-run supply curves for competitive firms slope upward for the same reason that marginal cost increases-the presence of diminishing returns to one or more factors of production. As a result, an increase in the market price will induce those firms already in the market to increase the quantities they produce. The higher price makes the additional production profitable and also increases the firm's total profit because it applies-to all units that the firm produces.

When the price of its product changes, the firm changes its output level, so that the marginal cost of production remains equal to the price. Often, however, the product price changes at the same time that the prices of inputs change. In this section we show how the firm's output decision changes in response to a change in the prices of one of the firm's inputs.

Figure 8.6 shows a firm's marginal cost curve that is initially given by MCi when the firm faces a price of $5 for its product. The firm maximizes its profit by producing an output of qi. Now suppose the price of one of the firm's inputs increases. This causes the marginal cost curve to shift upward from MQ to MQ because it now costs more to produce each unit of output. The new profit-maximizing output is q2 at which P = MC2. Thus, the higher input price causes the firm to reduce its output.

The Firm's Response to an Input Price Change

MC

cji Output

FIGURE 8.6 The Response of a Firm to a Change in Input Price. When the marginal cost of production for a firm increases (from MCi to MC2), the level of output that maximizes profit falls (from qi to qi).

If the firm had continued to produce q 1, it would have incurred a loss on the last unit of production. In fact, all production beyond qi reduces profit. The shaded area in the figure gives the total savings to the firm (or equiva-lently, the reduction in lost profit) associated with the reduction in output from <71 to qi

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