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ADAM SMITH: A Scottish professor (born 1723, died 1790) who is considered the father of modern economics for his revolutionary book, entitled An Inquiry into the Nature and Causes of the Wealth of Nations published in 1776.

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PERFECT COMPETITION, SHORT-RUN SUPPLY CURVE:

A perfectly competitive firm's supply curve is that portion of its marginal cost curve that lies above the minimum of the average variable cost curve. A perfectly competitive firm maximizes profit by producing the quantity of output that equates price and marginal cost. As such, the firm moves along its positively-sloped marginal cost curve in response to changing prices.
A perfectly competitive firm maximizes profit by producing the quantity of output that equates marginal revenue and marginal cost. In that price equals marginal revenue for a perfectly competitive firm, price is also equal to marginal cost. In other words, the firm produces by moving up and down along its marginal cost curve. The marginal cost curve is thus the perfectly competitive firm's supply curve.

Because the marginal cost curve is positively sloped due to the law of diminishing marginal returns, so too is the firm's supply curve. And because all firm's in a perfectly competitive industry have positively-sloped marginal cost curves, the market supply curve for the entire industry is also positively sloped. This offers a prime explanation for the law of supply.

Insight Into Supply

The analysis of the short-run production decisions for a perfectly competitive firm has direct implications for the market supply curve and the law of supply. The primary conclusion is that a perfectly competitive firm's short-run supply curve is that segment of its marginal cost curve that lies above the average variable cost curve.

A perfectly competitive firm produces the quantity of output that equates marginal revenue, which is equal to price, and marginal cost, as long as price exceeds average variable cost. The profit-maximizing choices of output at alternative prices generates the perfectly competitive firm's short-run supply curve.

Consider three key points:

  1. A profit-maximizing firm produces the quantity of output that equates marginal revenue and marginal cost (MR = MC).

  2. A perfectly competitive firm is characterized by the equality between price and marginal revenue (P = MR).

  3. The law of diminishing marginal returns gives the marginal cost curve a positive slope.
Combining all three points means that a profit-maximizing perfectly competitive firm produces the quantity of output that equates price and marginal cost (P = MC).
  • An increase in the price, moves the profit-maximizing quantity to a higher point on the positively-sloped marginal cost curve, and a larger production quantity.

  • A decrease in the price, moves the profit-maximizing quantity to a lower point on the positively-sloped marginal cost curve, and a smaller production quantity.

Working a Graph

To illustrate, consider the production and supply decision made by Phil the zucchini grower, a hypothetical firm. Because Phil is one of gadzillions of zucchini producers, each producing identical products and each with a relatively small part of the overall market, he has no market control. As such, Phil is a price taker. He must react to the price determined by the interaction of market demand and market supply, making adjustments in his own production to accommodate higher or lower market prices.

Short-Run Supply

This graph displays Phil's U-shaped cost curves representing his zucchini production. Note that all three curves (average total cost, average variable cost, and marginal cost) are U-shaped. The marginal cost curve is U-shaped as a direct consequence of increasing, then decreasing marginal returns.

As a profit-maximizing zucchini producer, Phil produces the quantity of zucchinis that equates the going market price with marginal cost. Phil's supply response to changing prices can be observed by... well... by changing prices then noting Phil's supply response.

One place to begin is with a price of say $4. A click of the [$4] button reveals that Phil maximizes profit by producing 7 pounds of zucchinis. The quantity supplied by Phil at a $4 price is thus 7 pounds zucchinis. This price/quantity supplied combination is one point on Phil's zucchini supply curve. What might Phil do if he faces different prices.

Consider a higher price. A click of the [$6] button reveals that Phil maximizes profit in this case by producing almost 8 pounds of zucchinis. This higher price induces Phil to increase his quantity supplied from 7 to almost 8. How about an $8 price? A click of the [$8] button reveals that Phil maximizes profit by producing about 8.5 pounds of zucchinis. Once again, a higher price motivates Phil to increase his quantity supplied. Bumping the price up to $10, seen with a click of the [$10] button results in an even greater quantity supplied, 9 pounds of zucchinis.

Does Phil reduce the quantity supplied if the price declines? Up to a point. That point being the minimum of the average variable cost curve, about $2.75. If the price falls below this level, then Phil shuts down production in the short run, incurring a lost equal to total fixed cost.

The conclusion from this analysis is that the marginal cost curve that lies above the average variable cost is Phil's short-run supply curve. A click of the [Short-Run Supply] button highlights Phil's zucchini supply curve.

Only Perfect Competition

This short-run supply curve explanation relies on Phil being a perfectly competitive price taker. The marginal cost curve is a supply curve only because a perfectly competitive firm equates price with marginal cost. This happens only because price is equal to marginal revenue for a perfectly competitive firm. Should price and marginal revenue NOT be equal, then a profit-maximizing firm does NOT equate price to marginal cost. As such, the marginal cost curve is NOT the firm's supply curve.

Because perfect competition does not exist in the real world, most real world firms do not have equality between price and marginal revenue, and thus do not equate price to marginal cost. In fact, real world firms with varying degrees of market power do not have supply curves comparable to that of an idealistic perfectly competitive firm. This recognition is a major stumbling block in the explanation of the law of supply and the role that the law of supply is plays in market analysis.

<= PERFECT COMPETITION, SHORT-RUN PRODUCTION ANALYSISPERFECT COMPETITION, SHUTDOWN =>


Recommended Citation:

PERFECT COMPETITION, SHORT-RUN SUPPLY CURVE, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2014. [Accessed: September 1, 2014].


Check Out These Related Terms...

     | perfect competition, short-run production analysis | breakeven output | perfect competition, profit analysis | short-run production alternatives | perfect competition, profit maximization | perfect competition, loss minimization |


Or For A Little Background...

     | supply curve | market supply | law of supply | law of diminishing marginal returns | perfect competition | perfect competition, characteristics | marginal revenue curve | marginal revenue, perfect competition | U-shaped cost curves | marginal cost | marginal cost curve | profit maximization |


And For Further Study...

     | perfect competition, marginal analysis | perfect competition, total analysis | perfect competition, efficiency | perfect competition, demand | perfect competition, efficiency | long run industry supply curve | perfect competition, long-run production analysis |


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